Tesla Motors (NASDAQ:TSLA) will announce Q2 earnings on Wednesday, and it's no secret that the numbers will probably be disappointing.
Bill Maurer wrote a fine article detailing how analyst expectations have been moving ever downward since February of this year, and the large deliveries miss (announced over the July 4th holiday weekend) due to "vehicles in transit" will likely weigh heavily on the quarter's financial results.
EPS will get a boost due to an increased number of shares resulting from the latest capital raise, but the boost will only occur because the "E" is a negative number. Not exactly terrific news.
The beacon of light for many Tesla supporters is likely to be Tesla's automotive gross margins. This number is traditionally 2-4 times greater than what is reported by other automakers and a source of pride for the Tesla faithful.
Q2 Gross Margin Improvement?
It is reasonable to expect that automotive gross margins could be higher this quarter than last for a few reasons. The most important of which is that (hopefully) most of the Model X production problems were resolved in Q1, leaving the door open to more efficient and profitable manufacturing in Q2
Also, the negative impact of the recent offering of 60 kWh X and S models won't have much effect until Q3.
Finally, Tesla may have still had some higher-margin Model X backlog to deliver in the first part of Q2.
All together, these items may bring some improvement to the recent downward trend of Tesla gross margins.
What Does This Mean?
Since gross margin is a metric that is touted by both Tesla management and Tesla shareholders, it is important to evaluate what the number actually means. This is particularly important if one is to compare Tesla to other car companies, or even just get a sense of what it costs to design, build, sell, deliver, and service a Tesla vehicle.
Gross margin is generally considered the incremental profit margin delivered by the sale of a product. In other words, the price of the product less the costs to produce it. And this works fine for companies with minimal variability in SG&A, or somewhat fixed cost of sales.
The thing is, Tesla's "gross margin" calculation is completely different from that of other carmakers for a few very important reasons.
This is NOT an indictment of Tesla, mind you. Tesla's business model, size, and relative age necessitate a different way of looking at things.
That said, it is important to understand what Tesla does NOT include in its gross margin calculations if we want to understand what it will take for Tesla to become profitable and grow into its current valuation.
Research and Development
R&D is a tricky item to report for Tesla. Over its 13-year history, the company has only developed 3 (soon to be 4) vehicles. Designing, testing, and bringing to market a new model is a VERY expensive proposition, though obviously a necessity for a carmaker.
Most (but not all) car companies consider R&D to be a cost of revenue. This means that R&D costs are included in the gross margin calculation for most of Tesla's competitors. They include the costs of developing future models into the margin calculations for current ones.
However, Tesla does not expense R&D as a cost of production.
In Tesla's defense, with such a small number of vehicles in its lineup, and selling only a relative handful of vehicles overall, accounting for R&D like other automakers would throw the numbers way "out of whack."
Would it be fair to include the billion-plus dollars spent to bring the Model 3 to fruition in a few tens of thousands of Model X and Model S gross margins? Probably not.
The obvious difference is that most automakers have much larger lineups and sell far more vehicles than Tesla, thereby reducing the per-car impact of this necessary cost of doing business.
But even if accounting for R&D like other automakers isn't exactly fair to Tesla, it is important to note that this is no small expense.
In 2015, Tesla spent over $700 million on research and development while selling about 50,000 vehicles. If Tesla reported gross margins like other automakers, gross margin would have been reduced by $14,000 PER VEHICLE.
In other words, more than half of the gross margin would be wiped out by including R&D in the GM calculation.
But much of Tesla's R&D in 2015 was for the Model X, and only a relative handful of those were sold in 2015. We also don't know how much of that R&D was spent on each model in previous reporting periods. This is the difficulty we face when looking at Tesla's true gross margins.
So, while it isn't improper of Tesla not to include R&D in its gross margin calculations, it is important to understand that there is absolutely a per-car cost to the expense that isn't included in the number Tesla reports.
This is part of the reason Tesla's gross margins appear to be so terrific in comparison with other automakers. It's important to understand, however, that these gross margins don't reflect the reality of per-unit costs.
The OTA Effect
As an aside, the over-the-air software updates that Tesla owners love so much create an interesting R&D problem for Tesla. While most carmakers are finished with R&D (or nearly, anyway) once the car is ready to be sold, Tesla continues to spend money improving cars without the benefit of future revenue streams.
Granted, the R&D that goes into updating those previously sold vehicles may also increase the desirability of products to be sold in the future, so only a percentage of that spending should/could be allocated to prior sales, but it is an interesting scenario all the same.
If anything, the real margins on Tesla vehicles get worse after they are sold.
Sales, General, and Administrative Expense
SG&A is a fascinating metric for Tesla when comparing it with other automakers.
As most everyone knows, Tesla has eschewed the traditional auto industry sales and distribution model of leveraging independent dealers to sell products to consumers.
The merit of selling direct to consumers is a conversation in its own right, though not a rabbit hole down which I would like to descend for the purpose of this article.
What is important to understand is that most carmakers don't have the expense of operating dealerships for vehicle sales and service. These costs are not insignificant, either.
Tesla, by choosing not to sell vehicles "wholesale" to dealers, has assumed all of the costs associated with operating sales and service centers. It also, presumably, can take advantage of the profits normally won by dealers.
But the increase in selling price (retail vs. wholesale) is already included in the equation. What gets left out is the incremental costs associated with the direct-to-consumer sales model.
What is the impact of this?
Take a look at this chart comparing SG&A per vehicle sold for different automakers:
Vehicles Sold (in millions)
SG&A Expense (in millions)
SG&A Per Vehicle Sold
I mean, really, holy smokes!
Now, before we go TOO crazy looking at these numbers, we must realize that some of this is due to Tesla's relative scale compared with its competitors.
But scale isn't the only problem.
For example, Ferrari (OTC:RACE) only sold about 7700 vehicles in 2015. Ferrari's SG&A expense accounted for 12% of revenues.
For Tesla, at greater than 50,000 vehicles, SG&A represented 22.8% of revenues.
Clearly, scale isn't the only problem.
The real problem is the costs associated with selling and servicing vehicles direct to the consumer, particularly when you have to sell vehicles in unprofitable places to keep growing delivery numbers (more on that below).
What it also tells us is that Tesla's gross margins are a terribly incomplete picture of costs per vehicle. Tesla incurs higher costs per vehicle than its peers because of how it sells its vehicles, and that should be considered when discussing gross margins.
The Growth Story Exacerbates the Problem
TSLA stock trades in the stratosphere because the company tells a terrific growth story. It has been achieving ~50% YoY increases in vehicle deliveries (though not revenues, which is interesting in its own right).
That type of growth excites investors, and maintaining the stock price is important when you need to sell shares to keep the company going.
But here's the rub. In order to keep the growth story intact, delivery numbers have to climb, at just about any cost. In order to achieve this, Tesla has to resort to two very unhealthy tactics.
The first is offering lower-margin, lower ASP (average selling price) products. This is demonstrated by the disappointing sales numbers in the first half of the year, and the resulting release of the 60kWh versions of the Model S and Model X.
Tesla supporters will argue that this is only happening because Elon promised the world low-priced options, and now he is delivering.
Whether Tesla is simply living up to promises it made in the past regarding pricing is irrelevant. What is relevant is that even Tesla's incomplete gross margin calculation is impacted by this.
The second problem is that, in order to increase deliveries and keep the growth story alive, Tesla has to ship cars all over the planet at great expense and for little return.
Seeking Alpha member xonkd summed it up brilliantly and was kind enough to allow me to share his comment here:
"...they have been justifying their valuation through growth by hitting low hanging fruit worldwide, which required an expensive expansion of sg&a. It also distracted them to the point that they muffed the foll out of the very critical Model X."
I won't go into the Model X rollout debacle, as that has already been discussed to death on these boards. Elon has admitted his own hubris in the design, so hopefully lessons have been learned and Tesla can improve in the future.
What is important to understand, however, is that selling directly to consumers creates costs that need to be considered when discussing gross margins. And, if you don't believe xonkd without some solid evidence to support his claim, take a look at Tesla's SG&A as a percentage of revenues over the past few years.
SG&A as a Percentage of Revenue
To make matters worse, take a look at the last four quarters:
SG&A as a Percentage of Revenue
These are really scary numbers. And, they are numbers that prove beyond any doubt that Tesla is selling in places it shouldn't (from a business perspective) simply to show investors that demand is healthy and the company is growing.
But the problem is that every new market that Tesla enters requires at least one sales and service center, and generally at least one Supercharger location. These are added expenses that aren't recouped unless sales volume makes it so.
This is not what's happening.
And, combined with price reductions, it is why Tesla is becoming more unprofitable as it sells more vehicles.
It turns out that Montana Skeptic was right: Tesla isn't production constrained and demand has become a real problem.
The Supercharger Problem
One other item that should be taken into consideration when looking at per-vehicle costs for Tesla are Supercharging stations.
The construction of Tesla Superchargers is not considered in either cost of production or cost of sales.
However, how many Teslas would be sold without the Supercharger network?
It's an interesting question. The better question, however, is how many Superchargers are required to increase sales in the regions where Tesla expands to capture that "low-hanging fruit" to which xonkd refers?
Will Tesla's Superchargers ever really become an asset? Or are they really just a cost required to sell a Tesla in the first place?
Again, I'm not accusing Tesla of impropriety in not listing Supercharger construction as a cost of sales. It is a tricky issue, to be sure. But I think even the staunchest supporters would agree that Tesla sales would be significantly reduced without the Supercharger network.
It's another area where what Tesla claims to be its gross margins don't reflect the reality of what it costs to sell a vehicle.
This is not a complete list of every expense Tesla could reasonably include in its gross margin calculations. It is merely an offering of a few factors that cause Tesla's gross margins to appear so fantastic.
At the same time, none of this article is meant to be an indictment of Tesla or an accusation of bad faith on the part of management. While not including R&D in cost of revenues isn't the norm for the auto industry, it isn't completely unheard of either. Indeed, doing so would even skew Tesla's numbers in a manner I would not consider realistic.
Along the same lines, not including SG&A in cost of revenues is standard practice, and there is nothing wrong with how Tesla accounts for this.
However, it is important to note that Tesla's gross margin calculation is seriously inflated in a manner equally not representative of reality. The undeniable fact is that Tesla has extraordinarily high SG&A per vehicle because of its sales model, and that needs to be considered when evaluating gross margins.
Gross margin by itself is a relatively meaningless metric. However, taken together, gross margin and SG&A tell a compelling story.
If gross margins actually contract in Q2, it is a sign of a very sick company cutting prices to juice demand or somehow incurring higher costs with increased production and negative economies of scale. This should be almost impossible if Tesla doesn't have a demand problem.
If SG&A accelerates relative to revenues, it is a sign that Tesla is spending investor dollars to gain customer nickels, and that is not sustainable either. I happen to consider this a more likely outcome for the Q2 results, and almost certainly for FY2016
Either way, I consider TSLA a sell at today's valuation.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TSLA over the next 72 hours.
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.