In our recent research note on Tesla TSLA, we discussed the company’s past profitability guidance. Since 2011, profitability has been just a quarter or two away according to management. Yet, barring a couple one-off quarters of razor-thin positive earnings, Tesla has been swimming in a sea of red ink for its whole life as a public company.
CEO Elon Musk has again asserted that profitability is right around the corner. Specifically, he expects Tesla to turn a profit in third quarter 2018. That’s this quarter.
With just over a month left in quarter three, Tesla is fast approaching the moment of truth. Will it defy the odds and post a profit? We are extremely dubious – as are most analysts. Even the most generous assumptions seem insufficient to tip the third quarter into the black.
In this research note, we look at a few models that have attempted to show how a profit could be eked out in the third quarter. We find that it is unlikely Tesla can turn a profit. Furthermore, even if it can squeeze out a technically positive quarter, it would be a one-off, unsustainable event.
Engineering a profit
A number of analysts and publications have tried to model Tesla’s third-quarter earnings in an effort to assess the plausibility of the company posting a profit. The Financial Times published one such article, in which it found that the chances of hitting profitability were slim:
"Even if we do adopt Tesla's 15 per cent gross margin forecast, our model shows a $53m loss next quarter. If Tesla manages to miraculously hit its long-term target of 25 per cent margins in the next three months, it will make it solidly into the black, recording $286m of profits. The latter seems particularly unlikely.
Tesla does have other levers to pull, such as selling Zero Emission Vehicle credits — state incentives which it regularly sells to other auto-manufacturers for a pure profit. In Tesla's sole profitable quarter in the last four years, the third quarter of 2016, $139m of sales from ZEVs pushed its income into the black. With competitors, such as General Motors, now producing electric vehicles en masse, it is unlikely Tesla will be able to book these one-time gains in perpetuity…
Remember, in this model we've made several conservative assumptions, often following direct guidance from Tesla when its record of hitting financial and production targets is, for lack of a better word, shaky.
As one example, we've kept operating expenses flat, despite Tesla's new tent-housed Model 3 line only being operational for the last three weeks of the second quarter. Not to mention the generous 25 per cent margins we attributed to the Models S and X."
Even using Tesla’s own guidance and making rather generous assumptions about production, margins and expenses, The Financial Times predicts a loss. With a bumber sale of ZEV credits, that could be turned into a profit. But selling off a raft of hoarded ZEV credits would be a lever than can only be pulled once.
Another analyst, Seeking Alpha’s CoverDrive, has an even bleaker outlook:
"A quick assessment of Q3 profitability can be made by taking last quarter's key numbers and applying reasonable assumptions from Tesla's guidance. In the spreadsheet below, I began with estimated sales and Average Transaction Prices for each car model, generating revenue numbers. I then estimated Gross Margins to calculate COGS. I think Tesla can achieve 15% GM on the Model 3 once they reach 5,000/week sustained production. However, they're starting the quarter with more than 11,000 cars built at Q2 margins. I think a GM of 12.5% is reasonable.
The "Other" row includes all other income and COGS not associated with automotive production. I used last quarter's numbers with a modest increase.
Operating Expenses are another key line item. Even if R&D does not increase, I don't know how they can deliver 84% more cars without at least a 10% increase in SG&A. There may be restructuring charges added also, but I assume most of it was reported in Q2.
Note that all of the numbers are GAAP. With the exception of ATP, all dollar amounts are in thousands. All gross margins are ex-ZEV. I have instead moved ZEV credits toward the bottom of the spreadsheet (Tesla will report ZEV in Revenue and Operating Income).
Even while reporting record ZEV credit sales, Tesla can be expected to fall some $236 million short of GAAP profitability. It's going to take some serious financial engineering (to use Galileo Russel's term) to report a profit. The peril is even greater if record ZEV credit sales fail to materialize."
This analysis makes more reasonable assumptions about expense growth and likely margins. The result is a quarter that is better than the second, but still deep in the red.
Progress report
The third quarter has been portrayed as a crucial one in which Tesla can prove it can be profitable. On the second-quarter earnings call at the start of August, Musk seemed quite buoyant and said this about his expectation of profitability in the third quarter:
“Based on everything we know at the end of July, it’s 1 month in. We’re highly confident of being cash flow positive and GAAP profitable in Q3 and Q4. And now there could be a force majeure event like an earthquake, something like that or a massive recession all of a sudden. But in the absence of that, of really unusual macro events, yes.”
If things were really turning around with Tesla on track to turn profitable in July, one would think that Tesla would be willing to say as much. Yet, when asked about progress in July, CFO Deepak Ahuja was cagey:
“We don't have July results done but it doesn't matter exactly where we are in the month of July. What really matters is over the quarter because it depends on deliveries, depends on production, many factors. So we will be significantly cash flow positive for the quarter. I think that's what really matters.”
That is a rather strange response. Quarters are made up of three individual months, after all. If one month fails to turn a profit, the next two will have to pick up the slack. Given Ahuja’s response, the reasonable conclusion seems to be that July did not end in a profit. But have things improved since?
According to a recent report from Electrek, as of last week just under 30,000 Model 3s had been built. That puts Tesla behind on even the low end of its production guidance, which called for building between 50,000 and 55,000 Model 3s in the third quarter. The production rate is crucial to reducing costs and improving margins. A slow start and continued lag in production does not bode well for Tesla’s guidance.
Verdict
Tesla appears to be trying to pull out all the stops to orchestrate a winning quarter. Yet even with all its efforts, it may not be enough. It is already abundantly clear that it will not be able to make a profit from operations alone. The question really is how many ZEV credits Tesla can sell, and at what price. It could rake in as much as $200 million through credit sales. That might be enough to push Tesla into the black. But that would be a one-off play.
Tesla has a lot riding on its third-quarter results. Right now, things do not look good for the bull thesis.
Disclosure: I/We are short Tesla via long-dated put options.
