While the broader market focuses on trivial issues like Asia, the Eurozone and an upcoming presidential election, a small but extremely vocal segment of the car shopping public is breathlessly awaiting the dawn of a new age with the first deliveries of Tesla Model S electric cars to customers on June 22nd. The excitement among fervent Tesla Motors (TSLA) acolytes is palpable, but I have to at least ask whether their view of the company's risk-reward profile is rational.
Is Tesla a great investment opportunity, or are we witnessing a weird form of transference that attributes a visceral hatred of oil companies and a love of flashy cars and speeding tickets to a moneyed adult population that couldn't care less? In four years of blogging about energy storage and vehicle electrification, the only truly compelling pro-EV argument I've heard is embodied in the mathematical equation: EV ownership = HOV lane access. The rest is coal smoke and mirrors.
Tesla's stock currently trades at space cadet levels of 19.9 times book value because the company plans to build 5,000 cars this year and 20,000 next year. With prices ranging from $57,400 to $105,400 (before subsidies), Tesla's potential revenue is huge, but I'm very unclear about who's going to buy all those cars. Seriously, how many people are willing to pay twice the national average salary for HOV lane access? Frankly I find Tesla's Ray Kinsella approach, "if we build it they will come," more than a bit disconcerting. In fact, it strikes me as a prescription for disaster.
In an effort to assess the reasonableness of Tesla's lofty sales ambitions, I started by cobbling together historical data from "Dashboard Reports" on the HybridCars website that break monthly green vehicle sales down by model and manufacturer. I learned that over the last year, sales of HEVs averaged 122,600 units per quarter and about two-thirds of those cars were made by Toyota (TM). Plug-in vehicle sales for the same period averaged about 9,000 units per quarter with the GM (GM) Volt taking the lead at 4,075 units per quarter, the Nissan (NSANY.PK) Leaf running second at 3,180 units per quarter and Toyota coming on strong with a plug-in version of the venerable Prius that launched in March and sold 3,638 units in three months. In comparison, green vehicles from Tesla and BMW in the Model S price range stumbled along at 262 units per quarter. Ouch!
While it's too early to reach firm conclusions about market behavior for new plug-in vehicles, the typical trend seems to be a respectable volume ramp for three or four quarters after a launch date followed by a sharp decline once the customers who were waiting for a particular model get their wish. When I study the following graph of quarterly sales for the leading plug-in vehicles, I don't see anything that even resembles a stable or sustained growth rate. As near as I can tell, the only reason for this year's surge in Volt sales was, you guessed it, HOV lane access in California.
Tesla began accepting reservations for the Model S in the spring of 2009. It reported 2,000 reservations in 2009, 1,400 in 2010, 4,600 in 2011 and 1,800 in the first quarter of 2012. In its most recent quarterly letter to stockholders, Tesla said the current Model S reservation tally is over 10,000 vehicles. Reservation deposits on those vehicles total about $105 million and are fully refundable until a sales contract is signed.
While it's a decidedly unpopular view among Tesla aficionados, I can't bring myself to believe that all 10,000 reservations are certain sales. In February of last year, Edmunds reported that only 40% of Leaf reservations became purchases. While I would expect a higher conversion percentage for Tesla, which requires a $5,000 down-payment instead of the token $100 Nissan requested with a Leaf reservation, the $44,900 to $79,900 that's due when a reservation becomes a contract is a big number and I have to believe that a meaningful percentage Tesla of reservation holders figured an interest-free $5,000 loan to Tesla was a fair price to pay for a place in line and two or three years of bragging rights. It will be fascinating to watch over the next few quarters and see how all those reservations play out.
Regardless of what you think Tesla's reservation conversion percentage will be, it's clear that deliveries of 5,000 cars this year and 5,000 cars per quarter in 2013 will eat through the backlog in short order even if there are no cancellations. From that point forward a sales organization that's never booked more than 1,800 reservations in a quarter will need to generate sales of 5,000 units per quarter to meet production targets. Given the pattern I've seen with other plug-in launches, I can't help but believe Tesla's 2013 sales targets are unattainable.
A troubling aspect of the upcoming Model S launch that many investors don't understand is that building and delivering cars will savage Tesla's cash reserves. When Tesla accepts a $40,000 reservation payment on Model S Signature Edition, the cash gets added to the assets section of the balance sheet and a corresponding amount is reflected as a liability. When the reservation is converted into a $105,400 sale, the liability is cancelled but only $65,400 in cash flows into the company's coffers. That cash, in turn, must pay all costs of manufacturing the car plus the unabsorbed costs of underutilized property, plant and equipment. In the early stages of a production ramp, those unabsorbed costs can be big enough to eliminate any gross margin that might have been recognized with full factory utilization. Investors who are expecting 25% gross margins on automotive sales will be sorely disappointed by dreadful second quarter margins, dismal third quarter margins and lackluster fourth quarter margins. Things may improve in 2013 if everything goes off without a hitch, but the next three reports of operating results from automotive sales will look pretty grim.
At March 31st, Tesla had $123 million of working capital and $154 million of equity. It lost $89 million in the first quarter and burned $50 million of cash in operations. While Model S sales will generate a couple million of incremental second quarter revenue, I expect the operating losses and cash burn to increase, perhaps significantly. Additional cash stress will arise from significant inventory builds that will be necessary to support Tesla's transition from development to production. Collectively, these factors will leave Tesla in a position where its June 30, 2012 financial statements look like an absolute train wreck unless it sells a substantial amount of additional stock within the next three weeks.
When Tesla did a $150 million follow-on offering in June of last year market conditions were pretty good and it was able to sell 5.3 million shares at a price of $28.76 per share. This year market conditions are aggressively ugly, investors are timid and the risks of an exciting but uncertain product launch are immediate. Under the circumstances I'll be surprised if Tesla can pull off another follow-on offering without a 10% to 20% discount from the market price.
I know all about Tesla's strengths and virtues including whiplash inducing acceleration and an iconic CEO who can build cars, launch rockets and take a solar panel company public at the same time while giving each company's business and shareholders all the time, effort and attention to detail they deserve. What bothers me are things I don't know, like:
- Whether Tesla can ramp production from under 200 cars a quarter to 5,000 cars a quarter inside a year;
- Whether Tesla will be able to avoid the delays, defects and recalls that plague competitors like Fisker;
- Whether 10,000 car reservations and $105 million in deposits will become revenues or refunds;
- Whether reservation rates of 1,800 vehicles per quarter can ramp to sales of 5,000 cars per quarter;
- How much additional working capital will Tesla need as it transitions from development to production; and
- Whether new investors will provide additional capital at a reasonable price or pull Tesla over a barrel.
In my view the market price of Tesla's stock doesn't reflect any of these real and substantial business risks. Since 33 years of representing developing companies has made me a firm believer in Murphy's Law, I spend more time worrying about things that could go wrong than I do dreaming about things that could go right. When things go according to expectations, a modest uptick is not unusual. When things don't go according to expectations, the downdrafts are often severe.
It could all work out perfectly for Tesla, but we could also see a situation where a minor problem, hiccup or delay sets off a chain reaction of unpleasant events. Historically Tesla's done a great job of managing expectations by telling investors that nothing good would happen until June of 2012. The long anticipated performance date has arrived and the carefree can kicking days of youth are past. Now Tesla has to execute to perfection or suffer the consequences of disappointment.
Disclosure: I have no direct or indirect interest in Tesla and nothing to gain or lose from its future stock price movements. It should, however, be an entertaining show to watch from the sidelines. I am a former director and current stockholder of Axion Power International (AXPW.OB), which has developed a robust and affordable third-generation lead-carbon battery for micro-hybrid, railroad and stationary energy storage applications.