Does Tesla's 10-Q Predict Future Profits?

About: Tesla, Inc. (TSLA), Includes: AMZN, FB
by: Tokyo Picker

FAS 109 requires management to take a 20 year view on US taxable profits.

Tesla management believes that it is "more likely than not" that there will be no material US taxable profit during that period.

As a result, a $1 billion asset is excluded from Tesla's balance sheet.

Tesla (NASDAQ:TSLA) management, speaking on last week’s conference call, made no projections as to when (or if), the company will come into profit. Probably wisely, they eschewed all financial projections and concentrated on production issues.

However, the requirements of the Financial Accounting Standards Board forced them to be more forthcoming in the latest 10-Q. Specifically, they said, in Note 2 to the Financial Statements, “Income Taxes: There are transactions that occur during the ordinary course of business for which the ultimate tax determination is uncertain. As of September 30, 2017 and December 31, 2016, the aggregate balances of our gross unrecognized tax benefits were $300.0 million and $203.9 million, respectively, of which $292.9 million and $198.3 million, respectively, would not give rise to changes in our effective tax rate since these tax benefits would increase a deferred tax asset that is currently fully offset by a valuation allowance.”

How does that disclosure reveal management expectations for future profit?

In order to answer this question, it is helpful to review how deferred tax assets and valuation allowances work. This treatment is provided for (and required by) Financial Accounting Standard 109.

First, let’s consider deferred tax assets. While there are a number of different varieties, the most important one, and the type we will primarily look at today, is the type relating to net operating losses - the opposite of profits.

If a corporation makes a $100 profit, the IRS will tax it - $35 at current rates. If it is in a state with a corporate tax, maybe the state will tax it also, but the IRS will give it a deduction for the state tax, so maybe it will owe the state $10 and the IRS $30 - $40 total. If on the other hand, it makes a loss, the tax authorities will let it carry the loss forward against the next several years' profits, so future tax will be reduced. In that way, a negative thing - the loss of $100 - has been partially converted into a positive thing - a $40 saving in future tax. Naturally that positive thing will appear as an asset on the corporation's balance sheet, improving the corporation's gearing and so making the corporation look healthier to investors. The accountants give this entitlement to future tax reductions the snappy title of a "deferred tax asset" or DTA. So, just to get our terminology straight, in our example we have a net operating loss or NOL of $100, and an NOL related deferred tax asset, or DTA, of $40.

While corporations generally prefer to avoid losses in the first place, they are more than happy to carry the resultant DTAs on their books (where they both increase shareholders' equity and off-set deferred tax liabilities caused by, for example, differences between tax and accounting depreciation and yet-to-be-taxed off-shore earnings) and to convert them into future tax savings. Amazon (AMZN ), to take one example, had an $82 million DTA on 12/31/16, while Facebook (NASDAQ:FB) had an $854 million DTA.

So, back to the 10-Q. Where is Tesla's DTA? There isn’t one visible on the balance sheet. Looking at Tesla’s losses to date of $4.3 billion, we would ordinarily expect to see a DTA of approximately $1 billion (the precise number depends on a state-by-state and country by country distribution of taxable income, as well as on differences between taxable and GAAP income). Why would Tesla leave such a substantial asset off their balance sheet? The answer lies in the valuation allowance to which Tesla refers.

A valuation allowance is used to remove from the balance sheet any portion of the DTA which management, in consultation with the auditors, feels is unlikely to be used. In the case of a US federal tax NOL DTA in the books of a US corporation, this means that the carry-forward period of the losses will expire before the corporation makes sufficient profits to use up the losses. For example, if a corporation, operating in a 35% tax environment has a DTA of $35 with a 10 year carry forward period, it can keep the whole DTA on the books if it expects to earn $100 or more during the ten year period. If, on the other hand, it expects to earn only $50 during that period, it will have to use a valuation allowance to reduce the DTA to $17.50 (being the amount of tax it would have paid during the 10 years but for the existence of the DTA).

Enough with examples - how about Tesla?

The 10-Q is short on details about this particular aspect of Tesla’s situation. To fully understand the position, we have to go to the more comprehensive picture in the 2016 10-K, Note 16.

TSLA 2016 10-K Note 16

Sure enough, we find the various types of DTA, including, our expected net operating loss carry forward related DTA Of $649 million. This is the asset which Tesla says, in the statement quoted at the beginning of this article, should be increased by $292 million as a result of the last three quarters, so that brings us close to our expected $1 billion. There some additional DTAs, in particular R&D credits of $208 million and general business credits of $105 million, which act, for tax reduction purposes, in very much the same way as NOL carryforwards. In addition there are some foreign and miscellaneous DTAs, beyond the scope of this article, which are offset by a similar amount of deferred tax liabilities. The net position is that there would be a deferred tax asset of approximately $1 billion on the balance sheet as of 12/31/16 (increased to approximately $1.3 billion as of 9/30/17) were it not for a substantially equal valuation allowance ($1.02 billion in 12/16, $1.294 billion in 9/17). The valuation allowance effectively wipes out the time limited DTAs. Why does Tesla have a full, 100% valuation allowance? To quote management (again from note 16), “Management believes that based on the available information, it is more likely than not that the U.S. deferred tax assets will not be realized, such that a full valuation allowance is required against all U.S. deferred tax assets.”

Tesla 2016 10-K Note 16 Management View In other words, management expects that Tesla will make no material taxable profits in the US during the period while the DTAs are available.

OK, no profits. But for how long?

The IRS and state taxing authorities do not allow companies to carry forward losses for ever. There is a time limit - usually 20 years for US federal purposes. Tesla helpfully details how this affects them (again in note 16 to the 10-K).

TSLA 2016 10-K Note 16 Loss expiry

In the case of Tesla's NOLs, federal carryforwards will start to expire by 2024 (since Tesla was established in 2003 but started to make substantial losses in 2004) and will all expire by 2037 - 20 years from now. The state losses start to expire earlier (primarily because California tends to change its rules often) but also continue finally until 2037. Therefore NOL related DTAs would, but for the valuation allowance, have some value until 2037. It is difficult to establish the final expiry of the R&D credits and the general business credits, but Tesla tells us that, but for the valuation allowance, they would have value until at least 2024 and 2033 respectively. Tesla believes that none of these assets will ever be realized. Therefore, it applies a full valuation allowance against all US DTAs.

The Bottom Line

Read once again, from Note 16, "Management believes that based on the available information, it is more likely than not that the U.S. deferred tax assets will not be realized, such that a full valuation allowance is required against all U.S. deferred tax assets." Then the confirmation from the September 10-Q, that nothing has changed: “a deferred tax asset that is currently fully offset by a valuation allowance” (my emphasis). These mean that Tesla’s management thinks that there is a less than 50% chance of any material US taxable profit by 2037.

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: Short via Puts