When Tesla unveiled their Model 3 at the end of last month, they received a record-breaking number of 325K orders in just one week. This number has recently been updated to nearly 400K. This created the sweetest problem any company ever had: How to fill this huge number of orders in a reasonable time to prevent attrition of orders. The company was not even planning to manufacture 400K cars - all three models S, X and 3 combined - before 2019. Last year, the company sold 50K cars and guides for 80-90K deliveries in 2016, representing a 70% increase from last year. Even if they repeat this meteoric increase in future years, they barely reach 400K (or, 417,605 to be precise) at the end of 2019. Would customers wait that long?
What options are available to Tesla?
In their original plan, Tesla was to start shipping Model 3 orders by the end of 2017. To do so, they promised that they would not borrow money or dilute shareholder equity by a secondary offering. How did they plan to achieve this? If they sell 80-90K units in 2016 and increase this by 70% in 2017, they should deliver about 144.5K cars in 2017. Thus, by selling a total of about 229.5K cars, or about $25B in revenues (assuming $110K per car), they expect to have earned enough money to build the manufacturing line and other supporting facilities needed for Model 3. The question that remains is: how will they find the money to manufacture their Model 3 cars even sooner and/or at larger numbers than their original plan?
I would be surprised if Elon Musk did not already have plans about possible alternatives. Even when the number of orders was around half of the current number, Elon Musk tweeted: "Definitely going to need to rethink production planning…" Production planning of "what" was he referring to? I contend that he was referring to production of Models S and X, since revenues from these models is supposed to pay for Model 3 expenses. This means, they will ramp up the production of Models S and X at higher rates than originally planned to be able to earn more money faster, and build Model 3 cars at larger volumes than originally planned.
Originally, Tesla was planning to increase production of current models by about 50K cars in 2017. At the end of 2015, Tesla's balance sheet already showed $1.2B of cash and $800M of unused credit line. With the influx of new cash coming from Model 3 reservations ($400M so far), Tesla is not cash-strapped at this point. However, they were planning to use this cash and future earnings in the rest of 2016 and the entire year in 2017 to:
- expand the supercharging network,
- increase the manufacturing capacity of the Gigafactory, and
- build the manufacturing facility for Model 3.
All three lines of investment are needed before Tesla can start selling their Model 3 cars.
If, however, Tesla wants to increase their manufacturing capacity by 50K this year as well as next year for their current models, they don't need to spend large amounts of money in all three lines of expenses immediately. The case for the supercharging network is easy to explain: Already, the supercharging network provides a driving distance of not more than 200 miles between supercharging locations in most of the target markets. The current models have far more than 200 miles of range per charge. Therefore, they don't depend on reducing the driving distance between supercharging locations. These superchargers have never been overly crowded with the exception of rare occurrences at a few locations. A relatively minor amount of investment can bring the existing supercharging facility to satisfactory levels at problem areas.
As for batteries, on October 29, 2013, they signed an agreement with Panasonic to buy 2B lithium-ion battery cells over the course of four years. This is enough for about 300K cars, but they already used more than 50K cars worth of batteries earmarked for Tesla. To build 229.5K cars by the end of 2017 as anticipated in Tesla's original plan, they need at least another 1.6B lithium-ion battery cells - probably more since Model X cars require more batteries per car. This uses up all the batteries earmarked according to the original agreement. They will definitely need more batteries from another source.
Last year, Tesla and Panasonic jointly built a Gigafactory to produce batteries at larger scales and lower cost. Currently, the Gigafactory is operating at about 15% of the full capacity. This factory will need to be expanded to produce more batteries for the immediate needs of Model S and X ramp up. According to the agreement between Tesla and Panasonic, the two companies share the manufacturing space, yet, they operate as two independent companies. Panasonic builds the battery cells in their half of the factory space and Tesla assembles them into battery packs. There are also independent suppliers (not sharing the factory space) that manufacture other parts of battery packs. Since each company pays for their own manufacturing equipment, the cost for Tesla's portion of the assembly line is much smaller than most people realize. Indeed, Tesla's total spending on the Gigafactory was planned to be $2B until the factory reaches its full manufacturing capacity. The rest of the CapEx would be paid by partners. If they want to double the current manufacturing capacity from its current levels of 15% to 30%, Tesla's share of extra spending would be no more than about $200M.
The major expense for increasing the manufacturing capacity of Models S and X would be the robotic equipment in Fremont, CA, factory, where the cars are actually built. The building itself has enough space to expand the manufacturing capacity for up to 500K cars per year, 10 times the production of last year. They only need to add more robots to the existing production line.
How much does a factory like that cost? According to this article, Tesla spent about $1/3B to build that factory initially, including the building, improvements, furniture and robotic equipment. Of this amount, about $42M was for the plant, leaving close to $300M for manufacturing equipment. At the time, the factory was designed to manufacture 20K cars per year. This means, one needs to spend about $150M for a manufacturing capacity of 10K cars per year. So far, they already increased the production capacity to about 100,000 cars per year. If they want to increase this capacity by another 50K cars this year, they will probably need to spend $750M on manufacturing equipment. This will allow the company to produce nearly 200K cars in 2017 (adding also the originally planned increase of about 50K cars per year).
Adding up the above numbers, we reach around $1B extra needed to double the manufacturing capacity for batteries and to increase production of Models S and X by extra 50K cars from the original plan. If this increase takes effect in six months from now, and continues in 2017, we are potentially looking at over 100K deliveries this year and over 210K deliveries next year. This corresponds to more than $34B in total revenues by the end of 2017, which is $9B more than the total revenues originally projected. Considering that this increase requires around $1B extra spending, it certainly makes sense to pursue this idea.
The existing cash and credit line would easily cover the total expenses calculated above. Increased sales volumes will also help increase the manufacturing efficiencies and improve profit margins. Therefore, Tesla should be able to pay for all of these expenses without using the credit line. The corresponding increase in revenues will then enable building the Model 3 sooner and/or at a much higher capacity.
To make a major change in their production plans, Tesla needs to coordinate with their partners and suppliers. Surely, everyone wants to sell more. But, each company has their own issues about their manufacturing capacity, commitment to other customers, promised supply volumes by their suppliers, increased labor force needed, the cash needed for more production equipment and so on. It will take time to reach a consensus between all the involved parties. It would be nice if Tesla was able to announce an increase in their delivery plans during the official earning announcement on May 4, but it would be optimistic to assume that they can finalize a concrete plan so soon. Three months from the date of decision seems to be a reasonable time frame to finalize the plans. This takes us to about the end of May or early June for the date of official announcement.
Effect on Stock Price
Increasing the production guidance will surely have a positive effect on the stock price since it will revitalize a buying interest among investors. However, this effect is likely to be minor, e.g. not more than about 10%. If the stock price is trading around $270 at the time, the announcement is likely to bring it to $300 area.
The reason for my anticipation of a minor increase in stock price is related to two factors: First, the announcement of increased production will also imply increased spending, thereby reducing the year-end GAAP profit projections. Second, short interest may increase soon after the announcement. In recent months, Tesla's short interest has decreased from about 34% of float to about 31% of float. The reason for this decrease has been the perception of reduced execution risk due to successful ramp up of Model X.
To elaborate on this last point, we need to understand why people short a company's stock. It is not small investors that determine the short interest. Rather, it is a large number of hedge funds that are required to invest a certain portion of their monies into shorting some stocks. This is the way they hedge their long investments against market risks. To determine which companies to include in their shorts portfolio, they look at the execution risk of each candidate company. To determine the execution risk, they usually look at the risk rating of a company's bonds. If a company has issued bonds in the past, there may be a risk rating of these bonds by the big three agencies, S&P, Moody's and Fitch. A company is not required to have their bonds rated by these agencies, but they may choose to do so (and pay hefty amounts of money to the rating service) if they think the rating will help sell their bonds.
In case of Tesla, the company has about $2.7B in convertible bonds, but they did not have their bonds rated when they issued them. In May 2014, S&P gave an unsolicited rating of B- which basically says that the company is below the minimum investment grade after evaluating a bond investor's chance of recovering their investment at 30-50% range in the case of a default. To reach a rating, an agency considers a set of "hard" factors and a set of "soft" factors. The hard factors include statistical measures such as the historical rate of default by other companies with similar cash flow vs. revenue figures. The soft factors include the company's track record in paying back their debt, competition by other companies in the business sector, growth potential, preparedness for competitive and technological shifts, etc. In all these areas, S&P evaluated Tesla as being weak or vulnerable, thereby justifying their poor rating.
Largely because of this rating, Tesla has been a favorite choice among the shorted stocks. According to the original growth plans, the cash amount of $1.2B they had at the end of 2015 was earmarked for future CapEx spending: for expanding the supercharger network, continued expansion of the Gigafactory, and expansion of the existing production capacity to produce more of the existing models gradually. In their analyst meeting after the Q4 earning announcement, they said that they expected to be profitable on GAAP basis despite the continued CapEx spending. This meant that the cash amount would increase at the end of 2016, not decrease.
What will change when/if Tesla announces that they will increase the delivery numbers of their cars to much higher levels than originally planned? It will mean that they will probably continue to report GAAP loss for 2016 in return for greater profits in 2017. Being already doubtful that the company can actually sell the stated numbers of cars, rating agencies (and indirectly the hedge funds) don't look at the future as much as they look at the past. No emotions or intent of harm is involved here; based purely on the risk rating calculations, hedge funds will continue to maintain or even increase their short holdings in Tesla. It is not in their DNA to cover their shorts just because the stock price may be going up. After all, they diversify their short portfolios just like they diversify long portfolios. Therefore, short interest in Tesla is likely to increase after such an announcement.
On the other hand, bullish investors who look further into the future will be impressed with the guidance that the company can increase their sales by about 50% in the next two years over and above already anticipated 70% increase, and doing so without borrowing money or issuing secondary offering of company shares. Normally, such announcements can catapult the share price of a company by significant amounts, but the increased short selling is likely to temper this rise of the stock price.
In this article, I explained why Tesla should be able to increase their revenue guidance by significant amounts without borrowing money or issuing a secondary share offering. The required increased spending would make the company more vulnerable to execution risks in the short term according to classical metrics, but it will pay back handsomely in the long term. As a net result, considering the factors favoring a movement of the stock price in both possible directions, I expect a modest rise after the official announcement.
In closing, I would like to comment on the "classical metrics" of execution risks. I find it rather amusing that people with Ivy League school diplomas opine about all types of big companies and issue investment advice. Never having run even a corner shop in their lives and without carrying out any sort of market research in that business segment, they will tell investors which companies are good investments and which companies are bad investments.
There are a lot of soft factors that classical measures of execution risk do not take into account. One major mistake made by classical models is their assumption that companies with more cash are more likely to be successful than companies with less cash. It is for this reason that we often hear comments like "bigger companies with significantly more resources will be a formidable competition for Tesla." This is like assuming that children of richer families are more likely to be successful in life than children of poorer families. This assumption fails miserably when we consider the fact that people like Steve Jobs, Bill Gates, Larry Page, Sergey Brin, Mark Zuckerberg and countless others came from families of modest means. Similarly, Tesla currently defines the EV industry, and is eating into the ICE market at an alarming rate.
One of the most important reasons for my long position in Tesla is the fact that the company CEO is the biggest shareholder, and a person who took over the company while they were still a baby struggling for their life and made them the best-selling company in their business segment. Comparing to career CEOs who are managing the competition, Elon Musk is more business savvy than all the rest combined. "How about the finances?" bears might ask! My answer is, Elon Musk is managing them with incredible skill, far more sophisticated than most people with accounting background can possibly comprehend. I often liken Elon Musk to a world-champion chess master, calculating every move with precision and valor. After all, he is the only CEO in the world who would spend all of his personal wealth to save his company when the company was having financial troubles during the 2008 market crash (see this article for more details). To add to the irony, this happened around the time when executives of banks that were saved from bankruptcy by the government awarded themselves generous bonuses and took $300K/day vacations in super luxury resorts with the money intended to save their banks from bankruptcy.
In conclusion, I find it very likely that Tesla will announce a significant increase in their delivery guidance for 2016 and subsequent years while the estimated GAAP earning for 2016 may decrease. This decrease in GAAP earnings would increase the execution risk according to the classical models of risk calculation, but I consider these risk calculations as nothing more than an academic exercise with little validity in the real world when applied to Tesla.
Author's Update, April 25, 2016: After publication of this article, some readers commented that the new high-speed production capacity has already reached 150K cars per year. This, if true, would strengthen the likelihood of an increase in delivery guidance.
Disclosure: I am/we are long TSLA.
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.