Press reports from the Tesla (NASDAQ: TSLA) Gigafactory opening media conference describe that Elon Musk has mentioned a "tens of billions" investment cost for all of the ideas mentioned last week in his "Master Plan Part Deux". Seeking Alpha also sent out a "breaking news" item this morning highlighting those comments.
But, there was a previous mention last week about such a possible figure which I described in my commentary about the updated Master Plan. Since Musk didn't provide any more details than just his ideas in that plan, I then did my own calculations quantifying the projects described by Musk. I also attempted to be conservative with my estimates as although I guess I am now included in the "Tesla Basher" and "whiny bear" camp, I really do attempt to be fair and balanced with anything I write. There is just so much material for comment about Tesla, however, and so I guess there always will be people who could be offended by any perspective that is different from the "saving the world" narrative of the company and its fans.
Although Tesla fans don't seem to concern themselves with minutiae such as costs, since Musk has now offered his own possible estimates it is now "game on" for more comments about such estimates. The first part of the game is "how do you finance tens of billions?"
Muskian Finance Theory
In addition to being a luminous and renowned visionary about rockets, sustainability, and Gigafactories, Musk also appears to be breaking new ground with innovative theories about finance. Just like Musk finally had the brainstorm after eight years of being CEO at Tesla to realize that "only three percent" of the Fremont plant was being used "volumetrically" he has apparently now had the brainstorm that "tens of billions" will only require a "modest" capital raise.
So, on what basis could that be true that only "modest" amounts of money will need to be raised? Maybe I just don't appreciate Musk's spirit of sustainability to leave as little of a "carbon footprint" as possible with his modest approach to things (although money being burned also probably leaves a carbon footprint!), but since I have lots of experience looking at how financial statements work, I know that much more than a modest amount of money will need to be raised.
Where Musk and I may differ about finance, it is apparently concerning what "gross margin" means. In the Muskian view, that apparently is the equivalent to free cash flow! Maybe I just get too bogged down in details but when looking at financial statements my curious little eyes then seem to go through every line item presented and so I then see those annoying things such as Research and Development expenses (which I've projected to be over $800 million in 2016) and Selling, General, and Administrative expenses (which I've projected to be around $1.4 billion in 2016). With those additional nagging little items that some pointy headed accountant who doesn't follow the narrative has inflicted on the company, Tesla's 2016 gross margin, which I've projected to be around $1.2 billion, is then completely eliminated as a source of "free cash flow."
But, and here is why all this matters. The second Master Plan is depending on Model 3 gross margins to finance the "tens of billions." Since Musk is also a big picture guy, and round numbers are far more exciting than more exact projections, we've been told that 500,000 Model 3 vehicles being delivered a year will provide $5 billion of gross margin to finance the tens of billions. The additional details about that are an average price of $40K per vehicle and a gross margin of 25 percent (as I said, round numbers just seem to make more sense!). I do have strong feelings that such margins will not be able to be achieved on the Model 3 as I look at the vehicle as having 60 percent of the costs of a Model S but only 40 percent of the selling price but maybe Musk will amaze us all and make it up in volume (and also start generating additional revenues by making that factory as a product too!).
Even if Musk is correct about the Model 3 gross margins, when you then go back to those other nagging little items such as R&D and SG&A expenses (which I project to be $4 billion in 2020), you then realize that the Muskian view of his hoped for Model 3 gross margin to contribute $5 billion a year doesn't really go very far as the net margin would be only around $1 billion a year. Overall production volume at the company in 2020 would also probably require at least $2 billion of ongoing capital spending as "maintenance CapEx" just to maintain existing production operations, without even factoring in additional CapEx for other ideas mentioned in the Master Plan.
There are other items that affect cash flow positively such as addbacks for depreciation and stock based compensation and I've projected those to be around $4 billion in 2020 but I've also projected there to be $500 million of interest expense that year as well. Adding up all of these things would result in projecting around $2.5 billion of actual positive cash flow in 2020. There are unfortunately two pertinent problems with those projections, however, which are 1) that my model is actually biased toward presenting the most positive view that I think is reasonable for Tesla's future results, and 2) the projections in Master Plan 1 for providing cash flow for future development did not ever happen at all!
Even if Musk's round numbers do become true, there are some significant offsets to the projection of $2.5 billion in 2020 cash flow depending on how Tesla proceeds with its various ideas. In my estimates of the projected costs and capital requirements for each idea described by Musk, each program would be roughly $500 million to $1 billion in development costs and then another $1 billion to $2 billion of additional capital spending to support each program. In addition to that, I've estimated that the broad software and systems initiatives described in the Master Plan would cost at least $2 billion in initial development spending. On top of the additional development spending for software and systems, but not included in my previous projections, is that software systems of such magnitude would usually require at least another $500 million a year in "maintenance spending" to maintain functionality.
When you put all this together one might think "hey, this should work" as my own numbers suggest that there could be $2.5 billion a year to support new programs. But, and this is a very critical variable, all of the projections assume that everything will work out as planned! The likelihood of that ever happening in any setting and for any type of project - much less for multiple projects all projected to cost in the range of $2 billion to $3 billion each - is very low.
There is also another nagging little detail in all of this which is that I've also projected that Tesla will need around $5 billion of additional capital between now and the end of 2019 to support the projected Model 3 ramp.
Since Musk is a larger than life guy, maybe future financing needs of $5 billion would be considered modest for him but as I've described in one of my articles, depending on the kindness of strangers to always be around to finance things is a pretty risky business strategy in my opinion. Financial markets are very fickle things and sentiment, both for the overall market and for individual stocks, can change very quickly. As such, a strategy based on always assuming that more money can be raised doesn't sound very sustainable to me. The current economic cycle is also running on fumes at this point and so there will be at least a mild recession which will affect financial markets between now and the end of 2019.
Are 500,000 Model 3 units a year a reasonable projection?
Another aspect of all these projections is: what are reasonable estimates of future demand for the Model 3? The current best-selling four door sedan in the U.S. is the Toyota (NYSE:TM) Camry which has deliveries of around 30,000 units a month, or around 360,000 to 375,000 units delivered a year in the U.S. The starting MRSP for the Camry is only around $24K, however, which is 30 percent below the projected base price of the Model 3. Fully equipped Camry's are usually priced at $32K to $34K and that would still be around 30 percent less than I what I would guess a fully equipped Model 3 cost of around $45K.
I realize that such numbers for comparative purposes are relevant for just possible demand in the U.S. and that the Model 3 will be exported as well but there are other factors that result in my believing that global demand will not be as high as Tesla may hope.
The first factor is that China already has a number of much lower priced electric vehicle competitors and which are also being supported with subsidies from the Chinese government. As such, I think that will be a difficult market for a lower priced Tesla vehicle.
Europe could possibly be an attractive market for the Model 3 but I believe there are some Tesla related issues that could be a factor in causing possible delays in the Model 3 being approved for sale. The factor in this case is all of the systems and electronics that Tesla is putting in its vehicles. To put it bluntly, it is one thing to approve the sale of a much higher priced vehicle (the Model S and Model X) that still has systems that are "in development" to a relatively limited number of affluent individuals but I believe the bar for Model 3 approval, which is intended for mass market purchasers, will be much higher. Remember that an often mentioned factor in the UK Brexit vote was recent EU regulations about tea kettles! If the EU feels the need to scrutinize tea kettles, I could potentially see a very lengthy testing period for an "automated" Model 3 before it would be approved for sale.
In conclusion about possible demand for the Model 3, while my own projections in my financial modeling article about Tesla do have 350,000 units a year projected for 2020, that is still not "almost" 500,000 units a year that would be projected to provide a gross margin of $5 billion a year.
There is also one other factor which I believe will inhibit some demand for the Model 3 and that is what I would call the infrastructure requirements for charging. The electrical work for a 240V circuit is usually around $1,500 to $2,000 and while that may not be looked at as much of an expense for someone buying a $100K car, that will probably be viewed differently by someone buying a $40K car. Also, since the target audience for a lower priced vehicle will have a lot more diversity in their housing characteristics, including a lot of potential buyers in that price range living in apartment buildings, I do strongly believe that there will be other infrastructure challenges to provide accessible charging resources for anyone who does not live in a single family home.
We've now finally been helped by Musk by mentioning that his visions could cost tens of billions in spending. We are unfortunately still in suspense, however, about what he means by only a modest amount of capital needs to be raised to support such ideas. Since Muskian finance is still in its own beta test, that could mean many different things. We've already seen an example of that this year where his projections of Tesla being cash flow positive for 2016 and not needing any additional financing that was described on the Q4 2015 conference call in February was then followed by a $1.7 billion equity offering in May.
Overall, however, there are just too many ifs in all this for me along with a stock at a very expensive valuation. Given the company's disclosure policies, it appears that there will always be surprises as to when money is spent (and how much) and also surprises as to the results of such spending such as late vehicle introductions, manufacturing problems, and missed delivery estimates.
One other notable item mentioned in Musk's media comments was that the Model S and Model X production lines were now being combined to make room for the Model 3 production line. With such a transition, I now understand why the previous head of manufacturing quit!
The timing of such a move is also very surprising given that we were supposed to believe that Model X manufacturing had finally been stabilized by the end of Q2. I guess I also have different views about things but I would have left the Model X manufacturing line on its own for at least two quarters to make sure that production processes were stable. Maybe Herr Hochholdinger is some sort of magician, however, and can somehow make all this work.
There is also one final thought that does give me a few laughs about all of this which is that it is very easy to announce all sorts of things and that investors are usually quick to overreact that such things might be true. A very funny memory of that was in 1987 (I've been around a long time...) when someone announced that they were planning to acquire Dayton Hudson (the whole company) with a purported buy-out bid. The stock suddenly raced higher for a few hours until subsequent scrutiny uncovered that the person behind the bid just thought that it was a good idea to acquire the company although…he wasn't in a position to line up financing for such a deal. Apparently the person had some sort of, umm "nervous condition" that resulted in such behavior. Yeah, that's something to think about!
Disclosure: I am/we are short TSLA.
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