Tesla (NASDAQ:TSLA) missed its Q1 earnings consensus by a mile. It is hard to find a company that misses earnings guidance as consistently as Tesla, but that is not necessarily good news for the shorts as the stock has proven to be resilient to bad news. Be as it may, in what was a stunningly bad Q1 earnings report, Tesla showed the world the horrendous nature of the company's business model.
Model S/X Plateau
One of the highlights (or lowlights, depending on the point of view) was that the company finally broke the "we are production limited" narrative. Commentary from the CEO, Elon Musk, suggests that the Model S/X growth story has now played out.
The company, pressed by analysts, reluctantly guided approximately 100K production for Model S and X this year. That is roughly 25K per quarter - about the same level the company reached in the last three quarters. The company kept its 47-50K guidance for the first half of the year, which means that Tesla is looking at a down Q2 what would otherwise be a seasonally stronger quarter. Even at the high-end of Q2 guidance, Tesla will have four quarters of no growth.
As the company exited 2016, it was capable of producing approximately 2,400 cars a week. Assuming a one-week shutdown each quarter, this production run rate translates to manufacturing capacity of about 115K cars per year. Of course, this capacity projection assumes that there is no future improvement in production processes going forward. In reality, Tesla now has underutilized production facilities.
Gross Margins and SG&A
There was a hint of hope in the earnings result for longs in the form of improved gross margin. At 27.4%, the gross margin appears high by industry standards. But appearances are deceptive when it comes to Tesla's unique business model. One of the biggest misperceptions about Tesla is that the gross margin is somehow comparable to other auto manufacturers. But that is not the case. Ignoring any expense categorization issues, traditional manufacturers sell products to dealers at wholesale prices whereas Tesla sells cars directly to customers at retail prices. To get a comparable gross margin number, we need to back out the sales and service expenses related to Tesla's retail sales channel. While this is difficult to do, let's get an idea of the scope of the problem.
Tesla's SG&A for the quarter was a staggering 29.6% of sales. In other words, Tesla's gross margin does not even cover its SG&A. We can hear some fans cry out: scale! As if that is somehow scale is a solution to this problem (more on this later). Setting aside individual investors, what is even more ironic is that there is a whole bunch in the Wall Street analyst community that is unaware of this simple dynamic.
Make no mistake - investors and analysts measuring this stock by the strength of gross margins are seriously mistaken.
Let's look at the P&L of Tesla. On revenues of about $2B, the company posted a net loss of $330M. That's a staggering 16.5% loss on revenues. Even excluding one-time items, the losses are horrendous. Note that these losses have very little to do with the capital expenses for the Model 3 ramp as that ramp has not begun yet.
We are sure scale will help but can scale make up for 16.5% losses or even 10% losses? We are skeptical.
With Model S and X sales plateauing, one would have expected that Tesla has reached scale and would have reached a high level of profitability. After all, the theme behind growth companies is that there will be profitability before the growth plateaus. After a decade of losses and multiple capital raises, by this point in time, investors should have been in sight of profitability. If "scale" is the mantra, there is no scaling to be done after a product reaches a plateau.
Here is the key takeaway for investors: The company is not profitable selling $100K cars when there is no competition and after the sales for the top-of-the-line models have plateaued. Can Tesla sell additional low-end cars with lower gross margins at $45K and make money?
Model 3 Will Not Be A Savior
With the clear slowdown of the Model S/X demand, we can easily see the bulls shifting the Tesla story to the high-volume nature of Model 3. But does that make any sense?
We do not believe so. A simple look at the economics indicates that Model 3 cannot be the savior. For the sake of discussion, let's assume that the ASP for Model S/X plateaus at about 100K units and $100K ASP with 30% gross margin. This implies that Model S/X gross margin contribution going forward will be about $3B (100,000*100,000*0.3).
Let's also assume that Model 3 will generate an ASP of $45K at an optimistic 15% gross margin. With this profile, to generate a gross margin similar to that of Model S/X, Tesla will have to sell 4.44 units of Model 3.
But even this math is misleading because it ignores the much higher SG&A it will take to sell 4.4x higher units. Going back to our earlier discussion about Tesla SG&A gross margin not even covering its SG&A, what will the higher SG&A required for Model 3 mean to Tesla?
Even if one were to be optimistic and assume unending capital market access to Tesla, by management guidance, Model 3 will not reach the level discussed above in 2018 profitably. It is entirely possible that the company could be bankrupt before even reaching this level. Even if the company were around, we are skeptical that Tesla can reach profitability with its current business model even in 2019.
Model 3 Osborne Effect
The assumption above is that Model S/X sales stabilize at the 100K level. But will they?
It is clear that, with its cool image, Tesla has attracted traditional non-luxury Toyota-class buyers to Model S/X. An untold amount of Tesla customers are buying Model S because it is the only "cool" BEV in the market. This type of value-conscious buyer will migrate to Model 3 if that alternative exists.
In context, we believe that the Model 3 Osborne effect may set in earnest as 2017 progresses. Given Tesla's track record with execution and the risks of Model 3 ramp, Tesla is in this dicey position where customers waiting for the Model 3 ramp could stop buying Model S/X and depress Model S/X sales level below the 100K unit level.
Therefore, it is no wonder that Mr. Musk took pains in the earnings call to differentiate between Model 3 and Model S with clear overtones that he does not want to see Model 3 "Osborne" Model S. However, to some extent, the "Osborning" is unavoidable.
We have been predicting for several quarters now that the SolarCity operation continues to shrink. As expected, the company deployed only 150 MW of solar systems in Q1 - this level of deployment is not only down sequentially and year over year but this low a level of deployment has not been seen since Q1 2014. The explanation from management:
"Rather than prioritizing the growth of MW of solar deployed at any cost, we are selectively deploying projects that have higher margin and generate cash up front. Consequently, solar energy generation deployments in Q1 2017 declined year-over-year, but had better financial results. Furthermore, the portion of residential customers who elected to purchase rather than lease a solar system grew to 31% of deployments in Q1, up from 9% a year ago, improving the cash generation of this business."
Ah, the futility of the SolarCity acquisition.
The management also continues to talk about synergies with SolarCity, but we are skeptical that many exist. And, to the extent that they exist, it is difficult to gain synergies with a shrinking operation. With the shrinking top line, we can expect further retrenchment in SolarCity operations. Getting rid of the uneconomical and inefficient SolarCity operations will cost Tesla shareholders some more moolah at a time it can ill afford the cash drain. We believe it is just a question of time before the SolarCity residential installation operation will dissolve into nothing.
New Ways To Expand Losses
One of the biggest weaknesses in the Tesla business model is the management's tendency to go vertical. Going vertical is capex intensive and almost always a near-certain long-term loser. There is a reason most industries, including the automobile industry, have stratas of service providers in the market. Each service provider picks a service opportunity that it excels in.
But not Tesla. The hubris at Tesla says the company will excel at each and every service opportunity in the industry. Thus, it comes as no surprise that the company found yet another new way to go vertical this quarter: Tesla-owned auto body shops. Why the management thinks that a public company based in Fremont, CA, can be more cost effective than mom and pop auto body shops is beyond us. One would think Mr. Musk would have learned this expensive lesson with the SolarCity experience.
The company also is expanding its capex and increasing its cost structure with the mobile service operation. We can certainly see mobile service improving convenience to customers but it will come at a steep cost to the shareholders. In addition to all the headaches the company has, now it also needs to manage a mobile service fleet and staff cost effectively with a public company cost structure instead of the traditional mom and pop cost structure. Once again, why the company thinks it can deliver the service more efficiently than mom and pop auto service businesses is beyond us.
What About That $4B Cash?
The company crowed that it has $4B cash at the end of Q1. That sounds good on the surface until we see that the company has a $2B+ of opex before Model 3 gets to production. On top of that, add all the cash burn of the current operations. Even if the company can arrest the cash burn at the current level, and it will not, we are looking at a situation where the cash will be substantially incinerated by the end of the year. While the company talks about internally generated cash, this is a dubious claim as the company has no history of generating cash flow and positive cash flow during the early stages of Model 3 ramp is highly unlikely.
Tesla will get capital infusions until there are believers, but the business model is hopeless. At the end of the day, what we have here with Tesla is a company with a terrible business plan and a storytelling CEO whose story rarely materializes. Even in the upside world of Wall Street, one day, investors will come to realize that there is no realistic story that gets Tesla to any meaningful valuation.
The question is when will the hardcore fans and big institutional investors realize this flawed business model and run for the exits?
It is hard to tell but we are skeptical this story can continue for too long. While it is hard to predict when exactly a bubble bursts, we believe we are at the cusp where the Tesla fairy tale is about to become a horror story.
Our View: Sell short.
Note: An expanded version of this article covering other aspects of the earnings call is available in the subscriber section.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.