Tesla's second quarter 2020 blew Street expectations in generating a 50 cent/share GAAP profit where endless debate focused around the odds of a loss.
That evening in the after-hour market Musk's superlatives propelled the share price to a peak of +8% or the addition in worth ($23 Bn) to roughly equal Ford.
This article focuses exclusively on the dominant surprise, the regulatory credits that represented $428m of profit of the $104m GAAP net income.
Mr. Market regained some sobriety by the end of following day, erasing Ford's value plus another $15bn, as Tesla closed down 5%.
Read on to understand why Tesla's Questionable Accounting for regulatory credits for the quarter and their vanishing prospects portend further downside.
Although there are many questions on what could be the world's most contentious valuation for a company, this article focuses exclusively on one issue: the regulatory credits for Tesla (TSLA). We'll take a deep dive into their source and explore their future sustainability. But most importantly, the article unmasks the 'Questionable Accounting' that Tesla employed for the June quarter to secure their inclusion in the S&P 500
Tesla reported $104 million in GAAP net income in the second quarter, but that profit included $428 million in regulatory credit profit (see page 4 of the 8-K SEC.
What is a ZEV or a Regulatory Credit?
The Zero Emission Vehicle (ZEV) program is a California state regulation that requires automakers to sell electric cars and trucks in California and 10 other states; the program is regarded as a template for most other countries.
The exact number of vehicles is linked to the automaker's overall gasoline and diesel sales versus EV sales within the state (i.e. sales mix), and over time (up to 2025), the threshold in the sales mix (EV:ICE) rises to avoid the emission penalty.
Naturally, this places Tesla in the enviable position of earning surplus regulatory credits that can be sold to an automaker that is still transitioning to lower emissions.
In other words, Tesla (100% EVs) has a temporary window of lucrative regulatory credits that the ZEV and EU-equivalent programs obligate all the other OEMs to purchase until their own EV:ICE sales mix is self-sufficient. Since the penalty is prohibitively costly, each OEM has an explicit target in its vehicle road-map to be compliant. For example, Fiat Chrysler (NYSE:FCAU) that reached an agreement in 2019 to purchase Tesla's regulatory credits (for EU), made a clear statement regarding its exit in the future.
FCA plans to launch a new electric version of its Fiat 500 minicar in Europe this year, along with plug-in hybrid versions of its Jeep Compass, Renegade and Wrangler models. That, combined with the Tesla credits, should make the company compliant
It's key to note as each OEM ramps up EV sales, the need to purchase ZEVs from Tesla diminishes. Through a simple balance of projected supply and demand, Tesla is fully aware that the windfall gain - both in terms of price and quantity - for each ZEV will decline.
Sure. I've mentioned this before in terms of regulatory credit. We don't manage the business with the assumption that regulatory credits will contribute in a significant way to the future. I do expect regulatory credit revenue to double in 2020 relative to 2019, and it will continue for some period of time, but eventually, the stream of regulatory credits will reduce.
If Tesla's regulatory credits will soon be in jeopardy, as cited by the CFO, Fiat Chrysler and Volkswagen above, the current buyers - other OEMs - need to make inroads into the EV market to generate their own ZEVs.
But Tesla owns the EV market
Tesla doesn't just dominate the EV market but owns it. Despite manufacturing defects like falling bumpers and poor paint finishes, even a skeptic has to concede the combination of Tesla's performance and Elon Musk's marketing genius has left the competition in a trail of virtual smoke.
Source: YouTube CNBC
Few doubt the intrinsic merits of the EV will progressively displace the combustion engine, but only a fool would assume Tesla's dominance won't be seriously challenged. Forget Tesla - The VW ID.3 might be the most important electric car of the decade.
Volkswagen throws the EV gauntlet in 2021
Volkswagen's first serious challenger to the Tesla Model 3, the ID.3 will make an electrifying splash in 2021. Although the physical July launch has been marred by COVID-19-induced lockdowns, the vehicle's reviews (performance, space, range, and value-for-money) have been outstanding.
YesAuto UK video release 24th May 2020: Will the VW ID.3 steal the Tesla Model 3's limelight?
Official VW video release last weekend: 25th July 2020: Volkswagen ID3 REVIEW - is this the EV game changer for everyone?
Remember with 35 million VW Golfs sold (arguably the world's most successful car since the 70s), VW's teutonic resolve, now recovered from Dieselgate burns, is back to challenge Tesla's EV dominance; rest assured it will merit more respect than Musk's characteristic hubris. Volkswagen ID.3 | Top Gear Review
Having supported my argument that other carmakers will gain EV market share as a primary and non-negotiable objective, it's time to move to the most important insight of this article.
Tesla's Questionable Accounting for Regulatory Credits
First an accounting preamble on a fundamental accounting concept: the matching principle. What Is the Matching Principle and Why Is It Important?
Matching principle is the accounting principle that requires that the expenses incurred during a period be recorded in the same period in which the related revenues are earned. This principle recognizes that businesses must incur expenses to earn revenues.
The principle is at the core of the accrual basis of accounting and adjusting entries. It is a part of Generally Accepted Accounting Principles (GAAP).
The simplest parallel to illustrate Tesla's Questionable Accounting would be an illustration on capital allowances a company would receive as an allowable deduction for tax. In simple terms, a company may be eligible for tax investment allowances or deductions from profit that may be made for its investments. As investments are lumpy from year-to-year, accounting convention mandates a deferred tax methodology, the creation of a provision to which a portion of the investment allowance is added in the investment year and, subsequently, released in the following year when investment was lower. This achieves the purpose of homogenising the corporate tax rate, rather than lumpiness that would result from bumper and fallow years of investment and their tax deductibility. That same methodology applies to create a Tesla repairs warranty provision and using it to charge repair expenses as incurred.
Well, if that methodology is applied to ZEV credits, the first point is to note they are awarded based on sales (more specifically the EV:ICE sales mix). Hence, they are awarded by the taxman (be it in California or the EU) on the basis of a carmaker's sales. It would (in my view) follow that a company should book them to align with quarterly sales. That would be, in my opinion, the direct reflection of the fundamental matching principle.
OK, I'm sure the reader has followed up to now, presented as plainly as possible to a non-tax and non-accountancy person.
It should then follow that Tesla should reflect the regulatory credits in booking the profit to match sales. Remember that is the basis by which the state awards the ZEV.
What would you think if Tesla does not do this? But what Tesla does instead is book the profit when it enters a contract to sell it.
I must add, this is explicitly stated in Tesla's accounting practices and not masked, as per the notes on regulatory bookings from the 2019 Annual Report page 43 (my emphasis):
Automotive Regulatory Credits
In connection with the production and delivery of our zero emission vehicles in global markets, we have earned and will continue to earn various tradable automotive regulatory credits. For example, under California's Zero Emission Vehicle Regulation and those of states that have adopted California's standard, vehicle manufacturers are required to earn or purchase credits, referred to as ZEV credits, for compliance with their annual regulatory requirements. These laws provide that automakers may bank or sell to other regulated parties their excess credits if they earn more credits than the minimum quantity required by those laws. Payments for regulatory credits are typically received at the point control transfers to the customer, or in accordance with payment terms customary to the business. We recognize revenue on the sale of automotive regulatory credits at the time control of the regulatory credits is transferred to the purchasing party as automotive revenue in the consolidated statement of operations.
To paraphrase the above in simple English, Tesla can choose when it is convenient to sell the credits. It is at the discretion of the company when the credits change ownership control. But my objection is that this does not in any way reflect the basis by which they are generated (on sales of vehicles). You see, in this case, if profit for a particular quarter is anemic and there are external circumstances that render a boost desirable, the company can simply arrange for their sale. This is precisely what transpired in Q2 - payment was unlikely to have been fully received as the accounts receivable increment of $211m is highly likely to include some of the regulatory credit debtor. Tesla probably entered a contract, during Q2, presumably under the preexisting long-term agreement with Fiat Chrysler to convert a $300m loss pre-regulatory-credits during the COVID-19 lockdowns into a GAAP 'profit-surprise' of $104m.
And hello to the S&P 500.
As a Chartered Accountant with 3 decades of experience, this is not congruent with the matching concept. Yet, to date, there have not been any regulatory questions from the SEC that have obligated Tesla to change their accounting here. However, I draw your attention to a new probe, initiated in February 2020. Could this relate to the Regulatory credit accounting?
The electric-car maker said the agency was also looking into contracts and "regular financing arrangements." Note this New York times article is behind a paywall; as is customary, neither Tesla nor the SEC disclosed the nature of the probe, save the headline emphasized above. In my opinion it is not unreasonable to assume the 'contracts' the probe is referring to is the regulatory credits.
If the booking of regulatory credits was in accordance with their generation - the quarter's sales of vehicles - an average over the last four-and-half years would be the smooth line below, easily implemented by provision accounting as Tesla does for warranty repairs.
Source: Personal instablog here, 14 hours of data extraction from PDFs to Excel.
What would Tesla's second quarter GAAP net income have been if a normalised regulatory credit amount was booked? Using the average (orange line above) of 0.21% of sales, the quantum would have been $193m versus the $428m actually posted. Hence the Questionable Accounting for Regulatory Credits is revealed.
And moving on to the medium term, what is Tesla's profit profile without regulatory credits? Sometimes a chart speaks a thousand words. The chart below shows (courtesy @TeslaCharts) the recent GAAP earnings record without regulatory credits.
Tesla Valuation: Beyond Aggressive
Shares of Tesla, which have more than doubled since the start of the year, climbed as much as 3.5% in intraday trading Wednesday, giving it a market capitalization of $207.2 billion, surpassing Toyota's $201.9 billion.
Tesla produced 103,000 vehicles in the first quarter, or about 4% of the almost 2.4 million made by Toyota, which built its brand on affordability and reliability backed by innovations in large-scale
However, the media was slightly off. Reason: it's only via the most recent quarterly release that investors see the fully-diluted share count has increased (more share-based compensation: $347m in Q2!) from 199m in Q1 to 207m in Q2. (see page 21 of the 8-K SEC after the patently more-important pictures!).
Using Tesla's fully diluted issued shares of 207m as per the 2Q 2020 financial release, the current market cap of Tesla is $305.5bn, meaning it eclipsed the value of Toyota as the most valued carmaker when Tesla's share price exceeded $848/share.
Forbes calculated a higher Tesla share price ($1,111 on 1st July versus my $848, as the 8m new shares issued as compensation were divulged last week) to topple Toyota as most valuable carmaker.
Current Market Caps as of closing prices on July 28 adjusting for Tesla's new share count
Tesla market cap $305.5bn
VW market cap $86.3bn
FCA market cap $22.0bn
Toyota market cap $172.9bn
Toyota sold 9,000,000 cars last year for a profit of $6,000,000,000.
VW sold 10,000,000 cars last year for a profit of $19,000,000,000.
Honda sold 5,000,000 cars last year for a profit of $4,000,000,000.
Total above: 24,000,000 cars sold for a profit of $29Bn in profits
Tesla sold 367,500 cars last year for a net loss of $862m
Tesla's market cap (as of closing prices on 28th July) stands at $305.5Bn (207m shares now o/s), which equals almost exactly the value of Toyota ($172.9Bn), Volkswagen ($82.3Bn), and Honda ($44.2Bn) put together ($303.4Bn).
Given the vehicle sales and profit of Tesla versus the other three carmakers mentioned above, the market appears to have erred materially in its over-estimation of Tesla versus an under-estimation of the three. This deduction would seem all the more conclusive when considering the shift in regulatory credit income, away from Tesla to the others. Despite my painful losses in my short position in Tesla, the conclusion I made has steeled my resolve to maintain my Tesla short. It's only a matter of time until the market realizes the extent of its Tesla exuberance.
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.