Auto manufacturing is an extremely capital-intensive, highly competitive and unforgivingly cyclical industry. Few new entrants are able to survive, so it is hardly surprising that Tesla (TSLA, Financial), an electric vehicle company, has been hailed as a great success of 21st century industry.
The jury, however, is still very much out on whether Tesla will be able to survive on its own in the long run. Indeed, if a recession were to take hold, as many economists fear is imminent in the next 12 to 18 months, it could prove an existential threat to the company’s survival.
Fighting to survive in good times
On Oct. 7, Peter Rawlinson, founder and chief technology officer of electric vehicle startup Lucid Motors, discussed the uphill battle Tesla has faced from its inception:
“Before Tesla, there was I would say an unwritten rule, but I think it was probably a written rule, that you couldn't start a new car company and succeed. It was impossible.”
Rawlinson, who was chief engineer for the Tesla Model S before leaving to found his own electric vehicle business, knows better than most just how hard it is to build a new car company from the ground up, and he has every right to be proud of how far Tesla has come.
Tesla, however, is still heavily reliant on external capital sources. It has had to tap capital markets with great regularity in order to fund its ongoing operations. Indeed, despite cutting research and development and capital expenditure to the bone in recent quarters, Tesla has been burning through cash at an alarming rate. In a Twitter response to Rawlinson’s comment, auto journalist E.W. Niedermeyer argued that declaring Tesla a success is still premature:
“Yes, Tesla has had more success than any other automotive startup in decades but the implication is that it has proven it has a sustainable business...which it simply doesn't. Tesla has proven that you can build a strong new car brand if investors pump cash in every 12-18 months. You can debate whether or not this regular reinvestment makes sense or will be worth it in the long run, but you can't pretend that it hasn't happened. Viable businesses, even those who prioritize growth over profits, don't need regular cash injections. Tesla isn't there yet.”
Tesla relies on frequent capital injections just to keep the lights on. Some observers claim the company is investing in growth, but in reality, capital expenditure and research and development have both been falling. In fact, in the second quarter of 2019, depreciation exceeded capital expenditure. In other words, capital expenditure was actually negative on a net basis, a strange move for a company supposedly on a rapid-growth trajectory.
A recession could be lethal
Tesla has been a veritable cash-incinerator for years, but its cash burn has intensified as it has made its stumbling foray into the mass-market with the Model 3 sedan. However, it has managed to continue chugging along thanks, in large part, to the market’s continued belief in a starry-eyed growth narrative. Investors have been willing to provide fresh capital on an almost yearly basis. Yet, the market’s patience is far from infinite. In May, when Tesla raised $2.4 billion through debt and equity sales, it did so on harsher terms than at any time previously.
When an economy is expanding, capital tends to move freely. Such has been the case during the long and stable post-Great Recession bull market. Yet, as Tesla’s growth narrative has faltered, so, too, has the widespread economic expansion. As fears of a slowdown, or even a full blown recession, mount in the face of ugly economic data and trade war uncertainty, companies like Tesla will find it increasingly difficult - if not impossible - to raise the sort of capital they need to keep operating, let alone fund the billions of dollars in promised (but unfunded) capital expenditure. As Niedermeyer pointed out, the belief that Tesla is “in the clear,” as expressed by Rawlinson, is anything but certain:
“The quote about Tesla changing the ‘rule that you couldn't start a car company and succeed’ has the ring of ‘this time it's different,’ which is always a warning sign going into a downturn.”
In the event of another recession, even one far milder than the Great Recession, Tesla may find the capital markets far less welcoming. Given the company’s ongoing reliance on external capital sources, that could push the cash-hungry automaker to the limit.
In recent years, Tesla CEO Elon Musk has made a habit of pointing out that Tesla is the only automaker other than Ford Motor Co. (F, Financial) to never go bankrupt. While that may seem to be a grand accomplishment, it has only been achieved thanks to the market’s extreme generosity. Tesla was a very different, far smaller company when the last recession struck. Its long-term liabilities and operating overhead were a tiny fraction of what they are today. Even a mild recession can disrupt spending on expensive goods, such as cars. Luxury cars tend to suffer worst of all, as consumers withhold spending.
Verdict
Tesla is already balanced on a financial knife-edge. In May, Musk admitted that the $2.4 billion raise would fund only 10 months of cash burn. With economic clouds gathering in increasing number and intensity, it is only a matter of time before the storm breaks. Tesla has little hope of becoming financially sustainable before then, if it ever manages it. Consequently, a recession would likely prove disastrous for the electric car company.
Disclosure: Author is short Tesla.
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