Tesla's Projected Earnings Are Sensitive To ZEV Credits - What If They Go Away?

| About: Tesla Motors (TSLA)

Summary

Tesla’s ability to swing from loss to profit (3Q 2016) was 100% dependent on getting ZEV credits dictated from California.

California effectively forcing other automakers to sell electric/hydrogen cars at a loss, is paid for mostly by people living outside California.

Either the automakers raise prices on non-electric cars in California or the Federal government should or could sue California.

Automakers would then be able to lower the prices on cars sold outside California, compensating for lower sales in California.

Will Ford, General Motors and FCA make this a priority in their conversations with Trump? If so, potentially a bad development for Tesla’s bottom line.

On its income statement, Tesla's (NASDAQ:TSLA) net margin is impacted more by California's ZEV (zero emissions vehicle) credits than almost any factor. For the most recently reported quarter - 3Q 2016 - it was plainly the single most important swing factor by far.

Tesla reported a $22 million profit, or $0.14 per diluted share. However, Tesla recognized $139 million worth of ZEV credits, which it had accumulated over several quarters, so without it, the loss would have been $117 million - or $0.78 per basic share.

What was the cosmetic value of being able to print a $0.14 per share profit versus having to report a $0.78 per share loss - even as many financial analysts saw through this factor's impact? We'll never know, of course, but the money is real: Tesla got $139 million from this government program, even if the check comes directly from the other automakers, not from a government treasury. It's a tax-and-subsidy in everything but name.

$139 million divided by 24,821 cars sold in the quarter is $5,600 per car on average. Yes, the $139 million was most likely accumulated over time, and it's not $5,600 equally for every car. It's a much larger amount for cars sold in California, and zero if the car is sold in Oklahoma, Osaka or Oslo. But again: The money is real. Tesla really got $139 million in cash in this most recent quarter alone, from the California-centered ZEV program.

It is therefore of critical importance to Tesla's financials and stock price to examine whether there is any scenario which could upset California's ZEV program in the future. If the Federal government were to prohibit it, or if some other political pressure were to cause California to reduce or eliminate it, Tesla would be faced with a huge hole in its margin structure, causing projected future margins to collapse, condemning the income statement to a higher probability of perpetual losses and negative cash flows.

As it turns out, there is one scenario which would have the potential for California itself to wake up and question the ZEV program. It has to do with California's non-electric car buyers having to bear the full burden of these huge electric car subsidies that currently are borne by all the other customers of Ford (NYSE:F), General Motors (NYSE:GM) and the other automakers outside of California.

In other words, it's an externality: Benefits accrue to one group of people - zero emissions car buyers in ZEV states, led by California - and the costs are borne by buyers of non-ZEV buyers everywhere, but most of them live outside California and other ZEV states. One group gets all of the benefits (but pay nothing), and a larger group gets zero benefits (but pay everything).

In every group of fifty, there's always that one who does something to drive up the costs for everyone else, without paying the bill himself or herself. He or she drinks half the punch bowl, and then pukes on the carpet. The other forty-nine pay for the damage.

In the automotive world, that one in fifty is California. Despite having the nicest climate in the country, a few cultists have indoctrinated themselves into an obsession with the idea that California has a problem with its weather, temperature, etc. In order to fix this problem with the weather, Californians must be forced to buy electric or hydrogen cars. By 2025, 15.4% of the cars sold in California are mandated to be such cars: here.

This childish policy of telling adults what products they must buy and sell is equivalent to forcing Nordstrom's and Bloomingdale's to sell a certain percentage of pants with a waist size below 30 because a government bureaucrat in Sacramento thinks too many people are fat. It is not the smartest approach to losing weight. All you do is creating an underground market for pants with larger waist sizes.

If consumers in California won't pay the true cost of developing and producing electric cars, the automaker is forced to eat all of this extra expense. As it stands, the losers in this equation are all the other buyers of non-electric cars inside and outside of California. Basically, some poor chap in Wisconsin or Ohio is forced to subsidize hippies and billionaires in San Francisco who want to drive subsidized electric cars at the expense of his fellow Americans, most of whom don't live in California.

Is there another issue that's more obvious than this one, for Trump to take a sledgehammer and hit as hard as the Department of Defense can bat? Considering that being forced to sell a certain mix of cars into a particular state is a restriction on interstate commerce trade, couldn't the Trump administration challenge California's ZEV (zero emissions vehicle) mandate under the Interstate Commerce Clause?

That would mean a court fight, of course. Well, good luck on that one, California. President Trump will soon fill the 9th seat on the U.S. Supreme Court, and any such case would therefore likely prevail in the administration's favor.

Alternative solution: Charge more for cars sold in California

In order to speed up the attention to this matter, it is way overdue for the automakers to start doing what they should have already been doing for years: Start charging more for cars sold in California than in the other states.

Hey, it's no different than telling one abuser of the system that he or she has to pay more to participate. If California raises the costs for an automaker by several hundred million dollars, or even billions, the people in California need to pay for that - not the people in the other states.

How much more should Californians pay? Well, there is no exact objective answer to that. CFA CEO Sergio Marchionne famously said that FCA loses $14,000 per Fiat 500e sold: here. And as we all know, the only reason FCA spent the money to develop that car was to satisfy California's ZEV mandate. As a result, it was a massive loss, a total write-off - paid for mostly by non-Californians.

Nobody knows how the FCA CEO came up with $14,000. One reasonable interpretation is that it's $14,000 per car in terms of variable losses. Then you would obviously have overhead - R&D, etc. - on top of that.

On the other hand, that was three years ago. The cost of making an electric car has gone down, primarily because of the falling battery prices. So maybe FCA is only losing $10,000 per car right now. But then you would have R&D and other expenses on top of that number, still. And you have other moving parts, such as retail (sale and lease) prices that continue to fall as a result of more EV competition.

Then you have the matter that you would have to spread these losses over a much larger number of non-electric cars. Let's call that a 10:1 ratio for the current planning horizon of 2020-2025 (it's a ratio which keeps narrowing from year to year). Using very crude math, you might want to think about the problem as $10,000 per car multiplied by a 10% electric car ratio, or $1,000 per non-electric car sold in California.

Maybe the real cost is actually higher as a result of the R&D and the other overhead, but let's say $1,000 for now. That means the automakers would be fully justified in raising the price on (non-electric) cars sold in California by $1,000 per car, right now.

The $1,000 could be listed as a "special California surcharge" on the window sticker: "We are adding $1,000 to the MSRP of this car in order to pay for subsidized electric cars sold to hippies and billionaires in San Francisco. If this $1,000 de-facto tax makes you sad, please call your Congressman to voice your opinion."

Alternatively, they could just call it "the Tesla Tax" which while technically incorrect would be sure to get to the heart of the matter, infuriating all the right people.

Yes, I know, the other states who are on California's coat-tails on this ZEV policy are as many as 16 in total: here.

Does that mean that the prices should rise by $1,000 on cars sold in all of those 16 states, or only in California - which is the "ring-leader" in this punitive plan anyways? Probably, but the effect might be sufficient if they started doing it only in California.

You might ask: Wouldn't this reduce sales of cars by any given automaker in California? Of course it would! Raising prices do that. So fewer cars would be sold in California (and as applicable, in the other states piggybacking on the same policy).

However, this would of course be compensated by higher sales for cars sold in the other 49 (or 34) states. Why? Because the automaker could lower the prices on those cars. Buyers of cars in Oklahoma, Texas, Nebraska et.al. would no longer be subsidizing hippies and billionaires in San Francisco, so the automakers would lower prices on cars sold in those 34-49 states to the tune of $200 - $1,000 per car.

Think about it. This is usually what happens when one state decides to tax a product. Residents in other states don't pay another state's sales tax. Or even an excise tax such as that on a cigarette pack. If one state adds a $4 per pack tax, that means that those people pay - not the people in another state.

What California is doing with the ZEV mandate is effectively imposing a tax on the people who don't buy an electric (or hydrogen) car. It's a tax in all but name. The difference is that California is getting away with consumers across all other geographies paying for it! It ought to be obvious that this is insanely unfair, economically as well as politically. I'm surprised that the automakers have given California a free pass on this - thus far.

The same thing goes for all other goods in society. If California imposes some law that makes it more expensive to build a house there, the guy who is building a house in Wyoming doesn't suffer.

If the automakers don't act on this, the consumers around the country have a case to bring against California. Why should they pay for subsidized luxury car consumption by hippies and billionaires in San Francisco?

There is an evident constitutional case against California's ZEV mandate as a result of the economic impact on consumers in other states. Either the automakers relieve those consumers of this burden by themselves or the Trump administration must sue California and take this to the U.S. Supreme Court. Of course, the same path to the U.S. Supreme Court would also happen if the U.S. Congress passed a law to this effect. The law would be challenged in the courts and the U.S. Supreme Court would eventually have to rule.

If California wants to induce people to buy electric cars, they could just increase the gasoline tax dramatically. Increase the gasoline price to European levels (or higher) and it will do wonders for the propensity to buy electric cars. Perhaps the voters in California wouldn't like this, but at least it would be constitutional, as it would not impose the burden to pay on people living in other states.

Positive impact on the environment

Getting rid of California's ZEV mandate would actually be an improvement to the environment. The cars that pollute the most today are the oldest vehicles, those that are over ten years old. As it stands, those are not the ones that are being replaced by electric cars. Rather, the people who are buying electric cars are relatively wealthier people who are replacing already relatively new cars. So the benefit is not as large.

However, if you can get one of those 10-30 year old cars off the road, that's a huge benefit in terms of reducing pollution. The way you do that is not to subsidize electric cars bought by millionaires who already owned relatively newer cars but rather by lowering the prices of regular cars that are selling for well below the average new car price.

For such a lower-priced car - say, $13,000 transaction price - being able to buy it for $200 to $1,000 less would mean that many more people could replace their old soot-spewing clunkers. That would reduce pollution in less wealthy areas too as they have the most old cars with ancient pollution controls.

Conclusion: Do it for the poor, do it for the environment

There are people all over the country who are now subsidizing California's tomfoolery with force-feeding of electric cars. It drives up costs tremendously for the automakers, and their customers everywhere around the country are now subsidizing this de-facto California tax.

That's not fair.

And it's bad for the environment, given that fewer people in Louisiana, Nebraska and so forth can afford to buy a new inexpensive car as a result. It hurts the environment and punishes the poor. All for the purpose of subsidizing hippies and billionaires in San Francisco.

Automakers: Raise your new car prices in California (and the other ZEV states) by $1,000 per car. And lower them elsewhere to compensate.

Trump: If the automakers don't deal with this injustice, you must act and declare California's ZEV mandate a violation of the Interstate Commerce Clause of the U.S. Constitution.

Will this be a subject in the conversations between Ford, General Motors and FCA (NYSE:FCAU)?

Impact on Tesla: Not good.

If any combination of the automakers and the U.S. Federal government put pressure on California's ZEV regime by shining light on it - and causing non-zero emissions car buyers in California to pay $1,000 more per car - that would put huge pressure to abolish the ZEV regime. And if that happens, Tesla's margins would fall dramatically, as exemplified by the 3Q 2016 EPS swing factor.

ZEV credits were a $0.92 EPS impact in 3Q 2016 alone, on Tesla's bottom line, swinging the company from a huge loss to a tiny profit. Imagine a permanent impact of even a small fraction of that number.

Disclosure: I am/we are short TSLA.

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.

Additional disclosure: At the time of submitting this article for publication, the author was short TSLA and long GM and F. However, positions can change at any time. The author regularly attends press conferences, new vehicle launches and equivalent, hosted by most major automakers.

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