On Nov. 16, S&P Dow Jones Indices announced that Tesla Inc. (TSLA, Financial) will be added to the S&P 500 on Dec. 21. The news immediately sent the electric vehicle maker's stock surging upward.
Unsurprisingly, bullish investors have proven ebullient about the prospect of Tesla's inclusion in a key index. However, a closer review of what Tesla had to do to gain admission to the S&P 500 should give thoughtful investors reason for pause.
Second time's the charm
The S&P 500 Index requires companies to have four consecutive quarters of positive net income to be considered. When Tesla reported its fourth consecutive profitable quarter in July, many investors saw index inclusion as inevitable, an expectation that caused the stock to climb over the course of the summer. However, the S&P 500 Committee opted to keep Tesla out of the index at its September rebalancing meeting, a move that Nicholas Colas of DataTrek Research characterized as surprisingly courageous:
"The S&P 500 Committee's decision not to include Tesla in the index just yet is about as brave a move as you'll ever see from this group. It can only have come from a collective and committed view that TSLA is profoundly overvalued and sits on shakier fundamentals than its mega market cap indicates."
Despite the September snub, Tesla's index inclusion hopes were far from dead. Indeed, after reporting a fifth consecutive quarterly profit in October, hopes of S&P 500 inclusion reached new heights. These hopes were vindicated Monday when the S&P 500 Committee finally agreed to admit Tesla.
Inclusion built on shaky earnings foundation
While Tesla has now reported positive earnings for five consecutive quarters, it is far from certain whether this profitability is sustainable over the long run. The biggest issue involves regulatory credits, which Tesla has relied on for almost all of its profitability to date. Indeed, credit sales accounted for all of its operating profit during the first half of 2020. Credit sales were also critical in the third quarter, accounting for 77% of Tesla's earnings before taxes. With the value of regulatory credits set to decline precipitously in the coming years as more automakers increase their electric vehicle offerings, Tesla will not be able to rely on them to plug its financial holes indefinitely.
Stripping out the impact of regulatory credits, one can get a more accurate view of the state of Tesla's core business of selling cars. Calculated on a four-quarter rolling basis, automotive revenues less credit sales have been stagnant despite continued growth in unit sales.
Making matters worse, falling average sale prices have eaten into Tesla's margins, erasing most of the benefits of increased volume. In fact, rolling four-quarter automotive revenues have actually declined on a per-share basis. That is hardly a good sign for Tesla's growth prospects going forward.
The cost of index inclusion
Things look even worse if one considers what Tesla had to do to secure four consecutive profitable quarters, even after benefiting from repeated credit sale bonanzas. Specifically, the company had to slash its capital expenditure budget and other internal growth investments to the bone. From a high of $3.41 billion in 2017, capex fell to $1.33 billion in 2019. Factoring in depreciation, Tesla actually had negative net capex last year, despite bringing a new factory on line in China.
In the first three quarters of 2020, Tesla spent just $2.01 billion on capex. While the company has promised a surge in capex in 2021, it has a lot of ground to make up. Tesla's increasingly overstretched service center infrastructure offers an illuminating example. Since 2019, the company has built an average of one new service center per week, which is far short of the pace of vehicle sales. The number of vehicles per service center has ballooned from 1,400 at the end of 2018 to 2,700 today.
Chronic underinvestment and short-term strategic thinking are already weighing on Tesla. Indeed, according to the latest reliability survey from Consumer Reports, Tesla is now the second least reliable major automaker. Reversing that trend is likely to prove expensive and may undermine its ability to continue reporting positive earnings.
My verdict
Tesla's imminent inclusion in the S&P 500 Index is undeniably a positive catalyst for the stock. With trillions of dollars invested in index funds, rebalancing will force substantial net index buying over the next month. Tesla's share price is already up more than 20% since the announcement. With index fund buying likely to soak up as much as 13% of the float, according to Evercore analyst Chris McNally, Tesla is likely to be buoyed still higher.
However, it is important to keep in mind what Tesla had to do to secure index inclusion, and what that may cost the company in the future. The decision to throttle back growth investment in order to show an ephemeral profit may have lasting consequences for Tesla's growth trajectory – and its ability to meet the market's wildly optimistic expectations.
My advice to investors is to trade the index inclusion news, and Tesla in general, with extreme caution. Great expectations are already priced in, but it is impossible to gauge when the market will reevaluate the company with a soberer eye.
Disclosure: Author is short Tesla.
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