Tesla: Q4 Invalidates The Bull Thesis

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About: Tesla, Inc. (TSLA)
by: WY Capital
Summary

Thinking that the main tenet of the short thesis is supply is well, short sighted, pun intended.

Demand improvements in Q4 are due to demand pull forward, which is short term and has most likely dissipated. Q1 demand would most definitely be a lot worse.

Tesla's profitability and FCF are most likely not due to operating leverage, but rather due to neglecting customer service and under-investing in long term projects.

We believe that the final $35k Model 3, if it ever arrives, will be so underwhelming and lacking in features that it would not be competitive with other electric cars.

Either way, Q4 actually invalidates the bull case, which hinges on high growth + ability to beat competition.

On January 30, Tesla(TSLA) reported Q4 2018 results, which sent the stock tumbling 5%, mainly due to a decline in earnings. One bull, however, has written an article that argues that Q4 was a good quarter and validates the bull thesis. However, we disagree with the bull's article and would like to present the opposing perspective - that Q4 instead invalidates the bull case.

A strong Q4?

The bull starts off by focusing on Tesla's share price drop and the missing of Q4 delivery estimates.

They also announced that they were cutting prices on all of their models by $2,000. The Q4 deliveries came in below consensus estimates, but the miss was minimal. And yet, the market is printing Tesla shares much lower now than their recent highs achieved on Dec. 13. The stock is now down more than 24% off the high.

We agree with this point. The initial drop based on a small miss in deliveries was unwarranted. The author goes on though, to state:

With regard to the financial results Tesla delivered, the company generated another profit, with higher than expected revenues and $910 million in free cash flow. This made for another strong quarter from Tesla.

However, the author ignores the fact that cash flow was only up because capex was down significantly. OCF was actually down around ~160mil while capex was down ~180mil. If capex had remained constant, FCF would be down to around ~720mil. We will revisit the consequences of slashing capex in more detail below.

The author also doesn't disclose that profits actually declined from Q3. In fact, both GAAP net income and net income adjusted for government credits and non-recurring items was down.

Source: 8K, WY capital

Interestingly, Tesla did not mention non-ZEV credits in Q3 when it helped prop up their net income and mentioned it in Q4 when their net income was down QOQ.

With deliveries and revenues being up and profitability being down, Q4 isn't actually a strong a quarter as the author believes.

That's not Tesla's biggest risk!

Next, the author makes the statement that Tesla's bears were most concerned about supply, or production.

However, the biggest concern that Tesla bears were voicing regarded the supply side of the supply/demand equation.

We're not sure which bears the author was referring to, but the majority of bears we have witnessed do not have "supply" at the top of their list of concerns. On SeekingAlpha, for example, more serious bear concerns have included competition, Musk's eccentricity, liquidity, just to name a few concerns. We believe that all of these concerns are more severe than the problem of not enough production.

The author continues by saying:

Yet, Tesla seems to have "worked out the kinks" with Model 3 production. In Q2, Tesla finally surpassed 5,000 Model 3s per week, a feat that they continue to sustain through to Q4.

What the author fails to realise though, is that the 5000 per week production in Q2 was a burst production rate and wasn't sustainable. BusinessInsider pointed out in August that out of the 5000 Model 3s produced in that week, 4300 required rework.

As expected, in Q3 and Q4 the production rate was much lower than 5000/wk. So far, Tesla seems to have only been able to produce over 5000/wk in more productive weeks (the week at the end of a quarter), and Tesla has never sustained a rate exceeding 5000/wk for a whole quarter.

We note that in 2017, Elon say there would be zero doubt a 10000/wk rate could be reached by the end of 2018. A list of Elon's broken promises can be found here, courtesy of Bill Maurer, but we do warn you, its quite long.

Next, the author mentions that:

Tesla is delivering sustainable production, the key factor in Tesla's ability to generate a profit in Q3.

The Q3 profit was made up of 189mil of tax credit sales, along with a cut in SGA and R and D. Some have speculated that lower warranty reserves helped increase profits as well. The theory doesn't make sense as well if you consider that Q4 had higher production than Q3, yet lower profit. There are many factors that affect profit, but sustainable production does not seem to be one of the deciding factors.

Demand in Q4 - Does it really matter?

The author moves on to demand, noting that:

75%-plus of total Model 3 sales came from new orders rather than backlog depletion. While this confirms that Tesla's backlog for higher priced Model 3 variants is coming under pressure, 47K+ Model 3 sales came from new customers.

This has already been dissected by author Bill Cunningham in this article, so we will not dwell on it. Bill has a much more lower estimated order count than the author's 47k estimate:

Source: Bill's article

If new orders in the US is this low, this should be quite concerning to Tesla shareholders, considering demand from September to December was artificially pulled forward by the incoming slashing of the tax credit.

Moving back to the bull's article, it does address the $7500 tax credit drop:

That being said, some of these sales might have been rushed in anticipation of the expiration of the lucrative $7,500 tax credit. Thus, the bears claim that we will see a plunge in deliveries in the first quarter.

The bull argues however, that Tesla has multiple levers to increase demand:

Fundamentally though, Tesla has multiple levers it can pull to extract higher demand for the Model 3:

  • The beginning of Model 3 leasing
  • International expansion
  • Introduction of lower priced variants
  • Marketing

We believe, however, that these levers would not be able to offset the demand cliff that is coming after January, for multiple reasons.

Starting with leasing, Elon himself explains why he's reluctant to pull that lever:

Well, we've been reluctant to introduce the leasing on Model 3 because of how - of its effect on GAAP financials. - Q4 earnings call

We note that companies like Enron also tried to make GAAP financials look as good as possible. Moving back to the author, the article does admit that Elon reluctance to lease is because he is obsessed with short sellers:

That being said, Musk also mentioned that leasing negatively affects Tesla's cash flow. And with Tesla's lack of cash flow being one of the talking points of the major Tesla shorts, we might not see an introduction of leasing until later on in the year.

The author does not seem to realize that it could be unwise to invest with a CEO that does not make the most rational choice but rather makes choices to try and impress short sellers.

We believe leasing, even if implemented, would not increase demand significantly, considering Tesla charges a high down payment for Model S and X leases and a high montly fee as well. Anyways, most car leasers are leasing to try and save money, and we're not sure money can be saved by leasing a Tesla.

The author then quotes Electrek, which is a pro-Tesla site. The author claims that Tesla:

is going to begin selling 3,000-plus Model 3s per week starting in February according the port handling company that's set to receive the vehicles in Belgium.

The link in the article, however, states that 3000 Model 3s are going to be delivered, not sold, to Europe. Tesla can deliver as much cars as they please, but without demand, they can't sell the cars. We estimate sustainable demand in Europe to be far lower than 3000/wk.

The author then states that:

Model 3 demand should really take off when Tesla opens up test drives in Europe. After all, consumer demand should further improve after consumers get to touch, feel, and drive the Model 3. Nothing is better than experiencing the product.

However, we note that a main tenet of the bull thesis a while back was that 400k people reserved the car in the US without driving or experiencing the car.

Elon, in the Q4 earnings call, has addressed the low reservations in EU and China, however, his answer doesn't impress us:

Yes, absolutely. The - I mean, we're not even really trying, I should point out. I guess it's - we - our factory is like, right now, only making cars for China and Europe.

It should be a major red flag that Elon says Tesla is "not even trying". Tesla has negative working capital and over $10bil in debt, but its "not even trying"? This does not make much sense. Even if demand is significant in Europe and China, cars cost more to ship there as shipping fees for such a long distance journey can add up, thus eating into Tesla's margins again. We also note that in many parts of the world people are on average poorer than in the US, so we do not have high expectations for international demand.

Next the author talks about decreasing the cost of the Model 3:

As Tesla continues to find efficiencies in assembly, and finds ways to lower this battery costs, they will be able to improve margins and begin production of the $35K Model 3 that hundreds of thousands are waiting for.

The author also believes that the base Model 3 will start being produced in Q3.

Personally, I'm expecting Tesla to begin assembly of the standard range Model 3 sometime in Q3.

Although the author may be right about this, there is no guarentee that this will happen, as Tesla has already cut costs to the bone and produced more cars in Q3 and Q4, yet its net profit still managed to decline. This could signal that Model 3 production has reached Minimum Efficient Scale, and any further scaling could result in dis-economies of scale. We also note that Elon himself has promised the $35k Model 3 a long time back and pushed the date back several times. But to be conservative, lets assume the base model 3 is released in Q3.

By that time, the tax credit would've halved again to $1875, and many features that exist in the current Model 3 would most likely be stripped out to cut costs. When hundreds of thousands of people reserved the Model 3, they were expecting a high quality, feature rich $35k car with a $7500 tax credit and superior customer service, like those that bought the Model S had received.

However, they would be buying a $33k car that most likely has very few features, poor quality, that comes with poor customer service. Will this be enough to make them cancel? We believe the answer for most of these people will be yes, especially when they hear about the Chevy Bolt and the Nissan Leaf, which retail at similar or lower prices and have lots of features.

Interestingly, when asked about reservations at the latest conference call, Elon declined to answer:

Yes, I mean, I think reservations are not relevant for us. We are really focused on orders. Now we do have a large reservations backlog still, which tells us that a lot of customers are still waiting for those cars, but I don't think it's appropriate to share the reservations number. - Q4 conf call

Next, the author makes the argument that Autopilot will be bought by most buyers:

Finally, the I believe the Autopilot feature will be purchased by the vast majority of reservation holders. While it does cost $5,000 for Autopilot, the majority of drivers have probably never seen a semi-autonomous driving system like Autopilot, and will be excited to use it.

We disagree with this statement on multiple levels. Firstly, many cars today have level 2-3 systems, which is what autopilot is. Also, most people purchasing the base version probably have limited cash, and so will try to cut down on unnecessary purchases like a $5000 software package. We will not mention the numerous crashes autopilot is linked to.

The author also argues that buyers would purchase expensive upgrades:

It would be naive to expect that all the $35K reservation holders would order the bare bones version of the car.

It would in fact, be naive to assume that $35k reservation holders, who do not have enough money to buy a more expensive model, would buy expensive upgrades amounting to thousands of dollars. We believe that the author's assumed ASP is much too aggressive.

The author ends off this section by quoting Munro:

That car is so over designed (refering to the Model 3). It isn't even funny.

We note that Munro had once praised the BMW i3, which is a competitor of the Model 3, by calling it the "Model T of our time". We also believe that Munro may have a conflict of interest as his firm sells reports on the Model 3. Overall, Munro is an outsider and is not expected to have any significant insight into the cost structure of the Model 3.

Tesla's Long-Term: Dismal

The author then argues that Tesla will do well in the long term:

The first is Tesla's ability to hit profitability and cash flow positive. While I will concede that we should get declining profits over the next few quarters, there's no doubt that the profitability story is headed in the right direction.

This statement seems to contradict itself. Is declining profits the right direction?

It seem short sighted to focus entirely on profits and cash flow, especially when a few years ago bulls were comparing Tesla to Amazon, praising how Elon was ignoring profits to improve the long term prospects of Tesla. Profits and cash flow do not matter that much when they are not sustainable and when you trade at a high multiple.

The author next mentions the Shanghai Gigafactory:

Tesla is one of the few companies that has been able to navigate China so successfully as a standalone brand. Gigafactory 3 in China will offer yet another increase in capacity, but, more importantly, allows Tesla to address the Chinese market directly, instead of shipping vehicles from the US.

We question how the Shanghai factory will be built considering Tesla is significantly cutting capex, as pointed out below, and as funding does not even seem to be secured.

In fact, Tesla seems to have painted itself into a wall by promising to build the factory by this year:

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. - Daily Kamban

With declining capex and R and D spend, Tesla's much hyped product pipeline looks a lot more distant.

Profitability and FCF

The author mentioned above had a sell rating on Tesla before Q3 and a buy rating after, so it seems the Q3 profit and cash flow was the key to turning the author's bear thesis into a bull thesis. However, as we will show, the Q3 results resulted from various dubious tactics used by Tesla to lower costs and boost revenues, dubious tactics that will have significant consequences in the long term.

Brand erosion and a nonexistent

Tesla bulls rejoiced when Tesla reported positive FCF and profits for Q3 and Q4, thinking that Tesla had finally shown operating leverage after years of increasing costs. However, as we will show, we believe a key contributor to profits is actually mainly due to a neglect of customer service, which could have serious implications on future profits.

Source: Statista

According to Statista, Tesla's brand could be worth as much as 9.42bil, so any significant brand tarnishing would be quite harmful to Tesla's value, even if not reflected on its income statement.

Unfortunately, this tarnishing is already happening. NPS declined from 96 around 2 years ago to 37 in 2019. Tesla now no longer has a industry leading NPS. Economic impact may be hard to quantify, but this may be one of the reasons for the extremely low demand in January.

Source: Customer guru

Other symptoms of a weakening brand are an increasing number of customer complaints, including Rich Rebuild's 4 video complaint on buying a Tesla CPO. Source: Youtube

These videos collectively garnered over 2.5mil views, most likely with a significant number of them coming from potential Tesla buyers. How many sales did these videos cost Tesla? We may never know, though we believe the economic damage could be well over a million.

Although these numbers are peanuts compared to Tesla's total revenues, there are many influencers like Rich Rebuilds that may buy a Tesla in the near to medium future. Poor servicing and quality could lead to even more complaints and more brand erosion. Interestingly, Tesla recently axed a quality control team in its most recent layoff.

We believe Elon Musk's plan is to find ways to reduce costs that don't directly affect current revenue, like quality control, thus making current profits at the expense of customer goodwill. This plan is not sustainable, however - One day it will either lead to a decline in revenues if Tesla ignores the customer or an increase in costs if Tesla listens to the customer.

If you're interested in learning more about the many quality control and service problems Tesla is facing, we encourage you to look into the YouTube channels of Tesla buyers and see their recent reviews. A significant amount of problems are also reported to the Tesla Motor Club forums.

Underinvesting in capex to show good FCF

Normally, you'll think a company like Tesla with a major product pipeline would not be hesitant to spend on capex, right? However, Tesla has decided to slash capex drastically. This should decrease future growth dramatically and therefore would mean Tesla would take longer to produce its much anticipated Model Y, Semi, Pickup etc, which we note is another part of the author's bull thesis:

Future products like the Model Y, Tesla semi, and potentially a pickup truck could all boost sales far beyond my personal targets.

We question how Tesla can stick to its stringent timelines especially when capex has dropped from ~800mil in Q4 2017 to ~300mil in Q4 2018. It doesn't make sense that a growth company like Tesla would invest so little in capex, especially when competitors are just starting to announce plans to mass produce EVs. In the short run, low capex would boost FCF, but in the long run, low capex will cause Tesla to miss their deadlines for product unveilings and capacity expansion.

To make matters worse, reducing capex also decreases Tesla's key competitive advantage, superchargers, at a time when companies like Electrify America will be putting up superchargers as well, which will compete directly with Tesla superchargers.

Of course, one could argue that most of the capex cuts were due to the full build out of Model 3 production, but we will counter that Elon's Model 3 production targets haven't even been reached yet.

Source: SEC filings, Graph from WY capital

Stop confusing EV love with Tesla love

Source: SeekingAlpha

A while back, this comment was posted by a contributor. We believe that this is what most Tesla stockholders think - Tesla is unique and its features can't be found anywhere else.

However, other than the 0-60 time, which most car buyers do not put much value in, everything else can be found in other EVs like the GM Bolt.

This proves that, other than its brand and supercharger network, both of which are being neglected by Tesla in search for profits, Tesla has no other competitive advantages.

The reason the competition short thesis about Tesla has failed so far is because Tesla invested large sums of money in supercharging, customer service and R and D. Now that they're not doing that anymore, their moat and competitive advantage is eroding, and so now one can safely make the case that competition will eat into Tesla sales.

Why Q4 actually invalidates the bull thesis

Investors that invested into Tesla in the beginning were most likely not investing to get a cash cow, but rather buying a company that would accelerate the transition to accelerate the world's transition to sustainable energy by providing a superior car to ICE cars and by weaning the world off fossil fuels. These investors were buying Tesla for its high growth and competitive advantages compared to other EVs like its superchargers and superior customer service.

In its quest for profitability and positive cash flow, Tesla has not only dramatically cut capex and R and D, which negatively affects the supercharger and first mover advantage Tesla has spent so much time and investor money to build up, but also dramatically reduces the quality of Tesla's once legendary customer service.

Is profitability worth so much to Tesla that it is worth undermining these competitive advantages that allowed it to become so large in the first place?

Tesla's mission, which is a key tenet of the bull case, is under threat from Elon Musk's desire to burn shorts. Q4 shows that Elon Musk is willing to do anything, even sacrifice its original mission, to gain profitability. Therefore, we argue that Q4 actually invalidates the bull thesis.

Some bulls seem to be aware of this, and are starting to sell large amounts of stock.

Source: holdingschannel.com

Source: @GrainSurgeon

Other bulls like Galileo Russell have noticed the customer service problems and is urging Tesla to become unprofitable again to try and quell the customer service problems, we quote:

...I wouldn't even care if we weren't even profitable in Q3 because we had to hire a bunch more customer service reps to facilitate smooth delivery processes

We encourage both bulls and bears to watch his video, as it brings up many interesting points.

Valuation

The most egregiously wrong part of the article was regarding valuation:

Along comes the innovative side of Tesla with the Model 3, and the company is generating billions more in revenue, finally justifying its "absurd" valuation. Tesla's future innovation, the innovation that some argue other automakers don't have, allows Tesla to command such a high multiple.

We believe this reasoning is quite shallow. Innovation is not a bull case. Snapchat, GoPro, Theranos, Blue Apron were all once hailed as innovative, but their premium valuation didn't last forever.

In the end, Tesla is a car company. It requires huge amounts of capital to survive and has low margins. Just because it is innovative does not mean it should deserve tech multiples. Tesla's business is cyclical, like other automakers. Tesla sells thousand dollar cars, not software.

Even an aggressive valuation for Tesla - annualizing its Q3 adjusted GAAP profit and giving it a 30x multiple, would still only yield a ~15bil company.

We looked back to the author's previous articles on Tesla to find other valuation methods. This was what we found:

While Tesla does trade at a much higher P/S ratio then Ford and GM, Tesla is growing revenues at 38% in 2019, while GM is flat and Ford is slightly negative. In addition, Tesla operates at ~22% gross margins, GM operates at ~12%, and Ford operates at ~10%. And in terms of solvency, Tesla outperforms the two competitors. And while all three companies have an increased chance of insolvency in the next two years, Ford and GM vastly underperform Tesla. Not to mention, Tesla's solvency is improving with every quarter that goes by as long as the company delivers profits and cash flows. To value Tesla, a growth stock betting on arguably the future of the auto industry against teetering titans like Ford and GM is an irrational move. Simply put, Tesla is a growth company while GM and Ford are in decline. In addition, Tesla is ahead in terms of deployment of electric vehicles versus GM and Ford. In addition, the ICE market is cyclical while EVs continue to take market share, accelerating the deterioration of Ford and GM's business.

The bottom line is, if you want to value Tesla's stock, you should value Tesla against growth companies, not legacy automotive peers.

We believe this valuation is flawed in many ways.

Firstly, Tesla reports gross margins differently from other automakers. They have retail shops instead of dealer networks, and they exclude many costs that legacy automakers include in gross margins.

Secondly, Tesla is not more solvent then Ford or GM - Current liabilities exceed current assets significantly. Ford and GM do have a lot of debt, but the debt is mostly due to the operations of their financial subsidiaries. Both companies have much more cash then Tesla.

Thirdly, Tesla is not a growth stock. It has stopped investing as much in capex and R and D ever since the Q3 profit, and so future growth will most likely be much slower.

Lastly, Ford and GM both plan to electrify many of their cars in the mid to long term, yet they continue to trade at low multiples. Both also have more advanced AV technology then Tesla, according to Navigant.

We note that the author did not give a valuation methodology, despite criticizing the valuation methods of others.

Outlook

Recently reported Q4 results paint a bleak picture of Tesla's future. In Q1, Tesla's Model 3s will what essentially amounts to a $3750 increase in price. That is a major deterrent for most potential buyers of the Model 3, who are most likely going to be from poorer backgrounds than those who buy the Model S or X.

Furthermore, as Elon himself said in the earnings call:

So January and February tends to be seasonally low and then picks up significantly around the early to mid-March time frame. - Q4 earnings call

Either way, with high fixed costs, very little revenue and the halving of the tax credit, Q1 likely will be brutal to Tesla. We believe that Tesla will revert back to a loss in Q1 and sales will drop drastically.

Q2-4 should show some improvement as cars are shipped to EU and China, but longer term, we believe Tesla is becoming more uncompetitive in an industry of efficient competitors and we believe this will show up in Tesla's stock price in the form of a steep correction.

Recent developments

Very recently, Tesla bought a tiny company call Maxwell Technologies. People on twitter have pointed out that Maxwell has negative operating income, SEC investigations, and a quick glance at its balance sheet shows that Tesla has paid 2x Maxwell's book value.

Source: @TeslaCharts

We also found this statement in Maxwell's 10Q:

The Company has incurred significant operating losses for several years and expects to continue to incur losses and negative cash flows from operations for at least the next 12 months following the issuance of these financial statements. - Maxwell's 10Q

Interestingly, Tesla paid for the Maxwell acquisition in stock, even though it has positive FCF and nearly $4bil in cash. The Maxwell acquisition supports our belief that Tesla is not hesitant about making overpriced acquisitions, like the SolarCity acquisition in 2016.

The Maxwell acquisition also shows that Tesla does not believe in its own stock, choosing to make acquisitions with shares that have fallen almost 18% from highs rather than using cash. If Tesla shares are worth $425 apiece, why is Tesla doing this then?

Conclusion

The bull thesis laid out by the author is quite flawed, and it ignores many of the challenges that lay ahead or the recent negative developments, such as the CFO leaving.

One could've made a bull case around Tesla based on its supercharging network and strong brand a while back, but this is not the case today. Both of these moats are eroding, leaving Tesla exposed to a deluge of oncoming competition. Elon Musk continues to display eccentricity and ignorance in the Q4 earnings call. Insiders continue selling stock like there's no tomorrow. Things are not looking good at Tesla.

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.