In a recent Seeking Alpha article, contributor Logical Thought, a hedge fund manager with a large short position in Tesla Motors (NASDAQ:TSLA), claims that Tesla's gross margin is deceptive. He adjusted it to show that it isn't really high when compared to competitors such as Porsche.
Logical Thought moved Tesla's R&D spending from Operating Expenses (OpEx) to Cost of Goods Sold (COGS) and moved the estimated costs of Tesla's stores and service centers to the Cost of Goods Sold from Operating Expenses. Since gross profit is revenue minus COGS, the newly-calculated gross margin was 5.1% compared to Tesla's stated 22.6% gross margin in Q3 2014. Logical Thought made these adjustments to make Tesla more comparable to Porsche on a gross margin basis. However, these adjustments mislead investors.
Where Do Research And Development Costs Belong?
Traditionally, R&D has always been part of OpEx and is accounted that way by most companies outside the automobile manufacturing industry. COGS, however, doesn't traditionally include R&D expenses because it is supposed to represent how profitable the actual product is (i.e., revenue minus costs to manufacture the product). However, the automobile manufacturing industry reports R&D as COGS because it can amortize model specific R&D costs over the lifetime of the model it is developing. This means that these companies can report higher net incomes due to the reduction of R&D costs, but smaller gross margins.
Logical Thought decided to move Tesla's R&D costs, which totaled $135.873 million in Q3 2014, to COGS to be comparable to Porsche. This brings Tesla's gross margin to 12.9%, compared to Porsche's 29.2%. However, the number Logical Thought moved up to COGS was $74.051 million (he wrote $75 million) because he amortized 52% (this is the same ratio as Porsche, which is arguably inapplicable to Tesla) of Tesla's R&D expenses over eight years and added them to the remaining 48%. However, it is worth noting that Tesla does not actually amortize R&D because almost all of its R&D is not model specific, which is why it reports R&D under OpEx rather than COGS. Therefore, one can conclude that this adjustment was done only for comparison purposes, and not because Tesla's incorrectly reports its gross margin.
But there is a major flaw in Logical Thought's analysis that makes it deceptive. By including the partially-amortized R&D costs in COGS, he actually increases operating profits while decreasing the number he is looking to compare: Gross profits. This calculation is misleading because Logical Thought doesn't mention the fact that bottom line profits would increase if he were to move the R&D to COGS. Tesla would have had operating profits that are $61.822 million ($135.873 million minus $74.051 million) higher than they were in Q3 due to the amortization of R&D. Based on this method of accounting, Tesla would have had a $0.45 per share profit on a non-GAAP basis instead of a $0.02 profit. Moreover, this would produce a profit of $1.86 over Tesla's last four quarters instead of $0.58.
Logical Thought also compares Tesla's ex-ZEV operating margin of -14.8% to Porsche's 18% toward the end of his article. This operating margin is the regular operating margin and does not follow his own adjustments to the accounting methods. It is misleading because he compares the worst of both gross margin and operating margin. Moreover, this operating margin doesn't include Tesla's revenue from leasing vehicles. Tesla's revenue from "leasing" vehicles (Resale Value Guarantee) should have been added and ZEV credits should have been included because Tesla includes ZEV when it budgets its money. Tesla also budgets with the assumption that all resale value guarantee revenue is recognized upon delivery. After making all of these adjustments, Tesla's operating margin for Q3 2014 (an unusually unprofitable quarter due to one-time expenses) comes to 4.2% compared to Porsche's 18%. In essence, it is only fair to compare Tesla's unadjusted gross AND unadjusted operating margins to Porsche's gross and operating margins or Tesla's adjusted gross margins AND adjusted operating margins to Porsche's gross margins. It is not fair to compare a mix of adjusted and unadjusted gross or operating margins.
Finally, this whole adjustment, even when accounting for all of its effects, is flawed because Tesla operates using a generally more conservative way of accounting for R&D (it might increase gross margin, but decreases bottom line profits). Tesla's current way of accounting fits its business model better because Tesla does not have much model specific R&D, which it can amortize. Instead, it has more general R&D costs. Therefore, it is fairer to leave Tesla's gross margin unadjusted because it allows investors to compare business models.
Overall, this portion of the adjustment turns out to be pretty misleading because it takes Q3 2014 gross margin, which was unusually low due to one-time expenses, and then subtracts partially-amortized R&D to show a lower gross margin number while ignoring the increase in operating margin. Also, the fact that Logical Thought quoted the unadjusted operating margin shows the real intent behind the calculations. Finally, the claim that Tesla's gross margin is not properly calculated is false because Tesla doesn't amortize R&D and doesn't do much model specific R&D. This means that Logical Thought's adjustments were done not because Tesla reports earnings improperly, but because he wanted to compare gross margins (while ignoring operating margins). Even when all these issues are fixed, the adjustment still makes little to no sense because leaving these numbers unadjusted would make it easier to compare actual business models.
What About The Dealer Adjustments?
Logical Thought also adjusted Tesla's margin down an additional 7.8% to 5.1% to make Tesla comparable to Porsche, a company that sells its cars to dealers, and thus get less than the MSRP. Logical Thought performs this adjustment by taking the typical 10% difference between the dealer invoice price and the MSRP and subtracting Autonation's (NYSE:AN) 22% gross margin to estimate the cost of Tesla's stores and service centers, which are the equivalent of Tesla's dealerships.
This adjustment is also flawed. At 7.8% of revenues and about 200 stores and service centers, this adjustment works out to a cost of $1.33 million per store/service center per year.
A "$1.33 million" service center (source)
A "$1.33 million" store (source)
Obviously, even when adding up all costs for these often tiny stores and service centers, you do not get to $1.3 million. The problem with the original calculation is that it subtracted the invoice price from the MSRP and then subtracted the dealer gross margin. However, you will almost never find a dealer who sells at MSRP, so instead, it is fairer to use the average price paid. The average price paid for the Porsche Cayenne is about 2% lower than MSRP. It is also clear that the average selling price of the Cayenne is inflated because the Porsche Panamera average price paid is about 4% lower than MSRP. Anyway, using the Panamera numbers (more comparable to the Model S) yields an additional cost of 4.68% rather than 7.8%. This works out to a cost of about $800k per store/service center per year.
However, this adjustment, like the R&D adjustment, is still flawed because it tries to force a comparison of two different business models by forcing one into the others' standards. It is much more relevant and much less artificial to compare the business models as they are rather than create an artificial comparison.
What About R&D Costs Per Car Compared To Porsche?
Logical Thought also compares Tesla's Q3 R&D per vehicle of $17,449 to Porsche's approximate R&D per vehicle of $12,000 and claims that even if Tesla ramped up to have the same number of models as Porsche and sell the same number of cars, it would only reduce Tesla's R&D per vehicle by a few thousand. However, this comparison assumes that Tesla has a relatively stable R&D per vehicle rate, which it doesn't. In 2012, Tesla's R&D per vehicle delivered was more than $85,000. In 2013, Tesla's R&D per vehicle averaged $8,742, which is much lower than Porsche's 2013 level. In 2014, R&D costs were back up to their current levels.
(Non-GAAP subtracts stock based compensation from R&D and adds Resale Value Guarantee revenue to the total revenue)
Obviously, Tesla's R&D per vehicle has a very different nature than Porsche's, and thus it is silly to claim that Tesla will only get its R&D costs down to Porsche's level if it matches Porsche in the number of models and sales. We do not know what level Tesla will get its R&D costs down to and trying to predict it isn't even speculation, its pure guesswork.
Scaling Up Production And Gross Margin
In Tesla's Q2 shareholder letter, Tesla mentioned their goal of reaching 100,000 delivery rate by the end of 2015 provided that there is good execution and no serious macroeconomic shocks. This number is huge compared to this years exit rate of about 50,000 cars per year. In Tesla's Q3 shareholder letter, they mentioned an annual growth rate of at least 50% for the foreseeable future. In order to accomplish these goals in 2015, Tesla has reduced the number of options by removing some and clumping others together in order to achieve higher production efficiency. The production growth that Tesla is aiming for will almost certainly result in higher gross margins as production efficiency increases with economies of scale. Moreover, the Model S D (all wheel drive) will result in higher average selling prices and also higher gross margins, and once Model X hits production, it will again increase average selling prices and gross margins. In other words, Tesla has a long ways to go in terms of increasing gross profit margin, and in the future, it might even match Porsche's margin even when "adjusted".
Why Is A High Gross Margin Important For The Stock?
Tesla's gross margin is supposed to hit 28% in Q4 2014 and will keep growing in 2015, perhaps even surpassing Porsche's 2013 gross margin of 29%. This is great news for Tesla investors because the high gross margin represents high potential for future net profitability and contributes to Tesla's high valuation. Tesla's currently negative net profit might inspire some short-sighted Tesla bears to short the stock, and thus give Tesla bulls many opportunities to earn money from short squeezes when the investment crowd realizes that current net profit margins are less representative of future net profit margins than current gross margins. Since Tesla is a maturing company, its operating expenditures are currently disproportionately high, and will eventually come down to a level at which Tesla is profitable.
Disclosure: The author is long TSLA.
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.