Tesla Still Stuck In The Mud In China

Summary

• Tesla claims its planned Shanghai factory will be up and running by the end of 2019 producing 3,000 Model 3 sedans per week.
• The company claims the cost of construction to hit that production rate is about $500 million and that this will be paid for almost exclusively via loans from Chinese banks.
• Tesla's claims defy all data concerning auto plant construction in terms of both cost and timeline - the ambitious projections are not supported the experience of seasoned automakers.
• Meanwhile, funding from local banks is still not secured; Tesla's negotiating power deteriorates as the year wears on, playing into lenders' hands.
• As Tesla's lofty China goals collide with a harsher reality, expect significant downward revisions to guidance and analyst estimates. The share price will follow them down.

Automakers rarely enjoy rich earnings multiples. Most are well-established businesses with most growth trajectories operating in a cyclical industry, so they rarely trade at rich valuations. Currently, the S&P 500 Automobile Manufacturing Index implies a forward price-to-earnings ratio of 6.2. Tesla (NASDAQ:TSLA) is a glaring exception: The upstart battery electric vehicle (“BEV”) company trades at a staggering 43.2 times forward earnings.

Tesla enjoys a massive forward multiple thanks to ambitious expectations of monumental growth across production, revenue, and profits over the span of just a few years. The problem for Tesla is figuring out how to get to the level of production and profit implied by its valuation in time - and at a cost it can afford.

One of the key components of Tesla’s growth strategy is its proposed Shanghai factory, which it claims will be able to produce 500,000 vehicles per year once complete. It also claims that the Shanghai Gigafactory will be up and running - and producing vehicles - before the year is out.

While Tesla has become somewhat notorious for making over-the-top promises regarding the cost and timeline of projects, the Shanghai proposal appears to be setting a new bar for optimism. Indeed, Tesla’s claims about construction speed and cost look increasingly fanciful.

In 2019, investors should expect Tesla’s high-flying stock price to waver as the reality of slower than promised growth sets in.

Fanciful Cost

We have discussed Tesla’s Shanghai factory before on Seeking Alpha and have made it quite clear that the company’s claimed timeline and construction cost estimates are wildly off the mark compared to industry peers.

In August, Tesla claimed the all-in cost of the Shanghai Gigafactory would come out to $2 billion. On its face, this cost looks radically optimistic. Auto analyst Bertel Schmitt recently pointed out that the starting cost of building an auto manufacturing plant capable of producing 250,000 units per year is about $1.5 billion, but it can be higher. Tesla claims not only to be aiming for double that production, but also to be producing the batteries for these vehicles.

Given Tesla’s plans for the facility, the cost is likely to be at least $4 billion, according to analysis from Goldman Sachs. Automakers with extensive experience building factories around the world run into far higher costs than Tesla predicts. The China plants constructed by General Motors (GM) in recent years, for example, had an average cost of $5.6 billion per factory.

Bottom Line: The idea that the all-in cost of the Shanghai Gigafactory is $2 billion looks absurd in light of all available data.

Fanciful Timeline

Cost is not the only aspect of the Shanghai project tinged with extreme optimism. The proposed timeline also makes little sense. Tesla claimed to be “accelerating” construction in December and orchestrated a January groundbreaking ceremony featuring a number of bigwigs from local and national governments.

Yet, for all the fanfare, the Shanghai Gigafactory remains little more than a patch of mud. Indeed, the area in which Tesla plans to build is swampland that has failed to spark the interest of other businesses, despite Shanghai’s efforts to spur development there.

Tesla has grown increasingly ambitious about its China timeline. In November 2017, CEO Elon Musk stated that it would take at least three years for Tesla to get a factory up and running in China. In August, he claimed production of Model 3 sedans would begin by the end of 2019. He repeated that claim during the January earnings call as well.

Tesla’s timeline is extremely ambitious, perhaps impossibly so. Indeed, an ordinary vehicle manufacturing facility takes at least two years to complete, with much of that time dedicated to setting up and calibrating production lines. And these are automakers with wide experience building facilities in a host of geographies and conditions. Tesla, meanwhile, has no experience at all of building an auto manufacturing facility from scratch. Its sole auto plant, based in Fremont, was a working facility for years before Tesla took over.

Bottom Line: To get a facility, or even a partial facility, up and running with all machinery working to spec in less than a year would be a monumentally tall order for a seasoned automaker. For Tesla, it looks like a lift well beyond its capabilities.

Doubling Down on Fantasy

During the Q4 earnings call on Jan. 30, Tesla seemed to be doubling down on its overly ambitious China plans. It reaffirmed its timeline, even suggesting Shanghai could hit a Model 3 production rate of 3,000 per week by year-end. That is hugely ambitious in its own right, implying construction of multiple assembly lines before the end of 2019. That's far more than a token production start.

The timeline was not the only element of the China factory experiencing a new high water mark optimism on the latest earnings call. Cost estimates also have apparently fallen, according to comments by Musk:

“I mean, as a ballpark figure, probably it's something about - something in the order of $0.5 billion in capex to get to the 3,000 vehicle rates in Shanghai, ballpark figure.”

So apparently it will take just $500 million to achieve volume production at 3,000 units per week in less than a year. Given the wealth of data available on auto plant construction in China - and around the world - we can surmise that this estimate is wildly off the mark. This is not simply a matter of repurposing an existing plant, as it did in Fremont, which still cost hundreds of millions of dollars to purchase and refit. Building a facility from scratch in questionable environmental conditions is certain to be costly and time-consuming.

Bottom Line: It is increasingly clear that Tesla’s goals are well out of step with the economic realities of this type of project.

Funding Still Not Secured

Tesla has been claiming for several months that funding will come from local sources, specifically loans from Chinese banks. On the latest earnings call, Tesla once again asserted this claim. According to CFO Deepak Ahuja, scaring up $500 million should be no challenge:

“The plan, as we have indicated in the letter, is still to get funding for majority of that capital spending from local China banks. And we expect pretty attractive rates based on the dialogue we've had. And there's a lot of interest. And we hope to finalize that and then share the details at that point...These are the biggest banks in the world, and for them, $500 million is not a large amount of money on the scheme of things.”

Musk chimed in as well, expressing similar confidence about the ability to secure sufficient debt financing and at a favorable rate:

“And as Deepak was saying, (indiscernible) very competitive debt financing in China, really extremely compelling interest rates, and we do not expect that to be a capital drain on the company.”

While claiming that building the Shanghai Gigafactory will not be a capital drain for Tesla sounds lovely, it scarcely comports with reality. While Tesla might be able to get $500 million in loans, that will obviously be insufficient to support the speed and scale of production promised. Even if we take the previous estimate of $2 billion, a loan even at favorable rates would present yet another significant debt burden for an already heavily leveraged company. But, according to recent reporting from Caixin, a Chinese financial publication, Tesla actually is looking for a lot more than that:

“Tesla Inc. is seeking loan bids to fund its $5 billion Shanghai factory.”

$5 billion, an order of magnitude more than claimed on the latest call. A loan of that size is difficult to fathom given Tesla’s present cash constraints and comparatively miniscule earnings. Were Tesla to actually seek a loan of that size, it would almost certainly come at a rate far less favorable than the company has implied thus far.

Bottom Line: Whatever the size of the loan, funding has not been secured as yet.

Backed into a Corner

Tesla has put itself in a very difficult position. It does not have the funding for its Shanghai Gigafactory, yet it continues to up the ante in terms of both cost and timeline. With January already behind us, Tesla now has just 11 months to make good on its promise of volume production in China. That plays right into the hands of Chinese lenders, as Bertel Schmitt has pointed out quite eloquently:

“By presenting the factory as a done deal that will churn out new cars before this year is over, Tesla hasn’t maneuvered itself into an enviable negotiating position with the gaggle of hungry Chinese banks.

“Part of the art of the haggle in China is the ability to get up, and walk away anytime. Instead, Tesla has openly hitched its future on the factory, and as far as the banks are concerned, Tesla painted itself into Shanghai’s muddy southeastern corner. No wonder Shanghai lenders are falling over themselves to cut a deal with the naïve lao wai (foreigner).”

With each passing day, Tesla loses negotiating power, which could further threaten the supposed favorable loan rates. At the same time, the upstart BEV company has lost most of its core finance team. Ahuja is stepping down as CFO in favor of Zach Kirkhorn, a young executive who was elevated to VP status in Tesla’s finance department less than a year ago. Meanwhile, the company is still down a chief accounting officer. A hollowed-out finance team is hardly the best thing to have when negotiating an existentially important financing deal with hard-nosed Chinese bankers.

Bottom Line: Tesla has put itself at the mercy of Chinese banks, something it is likely to regret.

Investor’s Eye View

The Tesla growth narrative is based on rapid growth of top and bottom line results, driven by massive increases in production and sales. Shanghai is the most critical element of that growth trajectory. But Tesla’s proposed timeline and cost make little sense. Worse still, there's no confirmed source of funding for the facility and as time wears on, Tesla’s negotiating power only deteriorates.

As 2019 wears on and the true cost and timeline of the factory’s construction becomes apparent, investors should expect significant downward revisions to forward earnings guidance and analyst price targets. That in turn will likely put considerable downward pressure on the company’s rarefied stock price.

Analyst’s 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.