Buy Tesla: Underlying Growth Story Still Intact

Sep.26.12 | About: Tesla Motors (TSLA)

Tesla (NASDAQ:TSLA)'s stock plummeted 10% after Elon Musk cut the 2012 revenue guidance because of a lower-than-expected production rate for the Model S, the car from which TSLA expects to make 90% of its profits for the year.

Not only this, Tesla will also have to speed up the repayment schedule of a loan taken from the Department of Energy (DOE) after receiving a waiver for breaching the existing loan covenants. This, coupled with the fact that Tesla is going for a second offering, has raised concerns amongst investors regarding the company's balance sheet weakness.

Production Hiccups and Resulting Changes in Revenues and Margins

Morgan Stanley (NYSE:MS) had already predicted before the announcement that the current production rates were not sufficient to meet the company's goal of producing 5,000 Model S cars by the end of the year. According to MS, Tesla will only be able to deliver 230 cars this quarter and 2,000 cars in the fourth quarter, producing a total of 2,250 cars for 2012. Tesla had told in its announcement that the company would be able to produce a maximum of 3,250 cars this year. In a bearish case, this figure could also be 2,700 cars. Therefore, this means that Tesla will not be able to make the revenues that are being expected by the Street. That is probably why Musk, Tesla's CEO, reduced the guidance from $560-$600 million to $400-$440 million.

However, MS believes that the sluggish production ramp-up of the Model S is "the worst-kept secret of the industry", and the fears of a slow rollout for the car are "overdone." The Street believes that Tesla should focus on quality rather than quantity, as the company has a history of compromising on the issue. TSLA was forced to recall the Roadster from the market after a fire incident made its way into the headlines back in 2010. We have already discussed production-related issues in our earlier article on Tesla, therefore, we will not go into much detail about this specific aspect in this report.

Delays from suppliers and certain manufacturing inefficiencies were the main reasons cited by the company for the slower-than-expected production rate.

Margins are expected to be hurt by the slower delivery of cars. Also, higher initial costs, manufacturing inefficiencies, and delays of service revenue from Daimler were held responsible for the weak forecast for gross margins in the third quarter. The estimated negative margins will range between 15%-18%. However, the company believes that the margins are expected to become positive in the fourth quarter as the planned cost reduction program is implemented. The gross margin for 2013 is expected to be 25%.

Loan Breaching and the Share Offering

In the press release, Tesla also mentioned that it has fully drawn the $465 million DOE loan facility. The following table shows the schedule of loan draw-downs by the end of June (all figures are in thousands):

Click to enlarge

There are certain financial covenants with which Tesla had to adhere to, as a requirement to the DOE loan:

  • Minimum current ratio.
  • Minimum fixed charge coverage ratio.
  • Maximum ratio of total liabilities to shareholder equity.

One of the requirements made by the DOE, according to Bloomberg, was that Tesla should maintain a maximum Debt/EBITDA ratio of 6.5x. However, after the announcement of delays in production, and the slashing of revenues, EBITDA is expected to be negative. MS forecasts the debt/EBITDA multiple to be -1.1x for 2012. Therefore, Tesla had to sit down with the DOE to amend the loan covenants. The relaxations included:

  • No restriction of maintaining a certain current ratio for the third quarter.
  • Postponed the pre-funding payment requirement from October 2012 to February 2013.

One covenant was added, which stated that Tesla would work in good faith with the DOE to develop an early repayment plan for the outstanding DOE facility. The deadline for this plan is October 31.

This amendment in the loan terms was the fourth amendment of its kind, after the previous three had been carried out in June 2011, February 2012 and June 2012.

The second share offering has been made in order to raise proceeds so that Tesla does not breach the current ratio requirement in the fourth quarter. The proceeds from 4.34 million additional shares are expected to be $128.3 million, or $147.6 million if the underwriter, which is Goldman Sachs (NYSE:GS), decides to exercise the options in full.

According to Tesla's CFO, Deepak Ahuja, the company will be able to pay back the loan in less than 10 years, in case it becomes profitable ahead of schedule. However, the current scenario does not reflect much positivity, especially after the production rate failed to meet expectations.

Tesla is expected to start paying back the loan principal by December this year. The repayment schedule for interest payments has already started from February. According to a DOE spokesperson,

"Tesla has always made loan payments in full and on time."

Cash and R&D

Currently, Tesla possesses $228 million in cash reserves, of which $25 million amounts to restricted cash, which is yet another requirement of the DOE loan. The sell-side expects the cash balance to be $130-140 million by the year end, net of the new shares proceeds. Tesla expects free cash flows to reach a breakeven by the end of the fourth quarter, which is optimistic when compared to sell-side estimates of a -$300 to -$400 million FCF for the year end.

R&D is expected to decline by 20% for the year, as a material amount of manufacturing costs will be shown, for the first time ever, in costs of goods sold and not R&D costs. SG&A expenses are expected to rise modestly by 3%. CAPEX will be in a range of $220-$240 million, rising almost 10% YoY.

Demand

Qineqt has, time and again, stressed upon the fact that the Model S does not have a demand issue. Many perceive that the Model S is competing against other electric cars, which is not true. The features that the Model S offers are far superior to those of the Volts and Leafs of this world. They match those of luxury sedans like the Porsche Panamera Turbo S or the BMW M5. This is why despite the fact that manufacturers have been cutting production guidance for electric vehicles (EV) Tesla has remained steadfast with its ideas. Recently, Toyota (NYSE:TM) declared that it was stepping down from its plans of increasing production of EVs, as it has misread the market, and demand is much lower than what was earlier anticipated. General Motors (NYSE:GM) also closed down the EV Volt's plant due to low demand. That is probably why the figure of 1,200 reservation cancellations has triggered concerns amongst investors. It is also worthwhile to note that reservations have shot up from 11,500 to 13,000 in less than three months, which means 13% growth.

Valuations and Conclusion

The 10% drop in the stock price on the news was a surprising one, as the slower production ramp-up, and the second offering by Tesla were already being anticipated by the market. The financing issue has also been solved to a certain extent, as the company goes out for the second offering of shares. Perhaps the market is wary that Tesla may not be able to deliver 20,000 Model S cars next year, as it has not been able to meet its target. The sell-side also believes that Tesla may not be able to produce more than 15,000 cars next year.

A lot of bad news has already been priced in the stock. Much of the main concerns have been addressed after this SEC filing. The stock is expected to move up from here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Industrials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.