The hidden message in Tesla’s earnings call

Tesla, the American electric vehicle manufacturer, reported earnings yesterday. And although losses doubled in the latest quarter, most investors were positive about the results. Tesla’s stock rose 9% in extended trading, after closing Wednesday at $300.84. As I write this, the stock is trading just above $330 a share, up over 11% from yesterday’s close.

The positive reception is both because the cash burn in the quarter was lower than anticipated and because of the (always) upbeat outlook the company gave. I think this is make or break time for Tesla. So let me give the numbers highlights briefly and then get into the hidden message of the earnings call.

The numbers

  • Q2 Cash burn:  $739.5 million. That’s down from a quarterly burn rate of about $1.1 billion. I think this is the most important figure.
  • Q2 free cash flow: $430 million
  • Cash: $2.2 billion (the lowest in 2 years)
  • Production guidance:  6,000 Model 3 vehicles per week (or 300,000 per year) by late August. 7,000 vehicles per week next year (or 350,000 per year) ending 2019 at a 10,000 car per week run rate (500,000 cars per year)
  • Quarterly revenue: $4 billion
  • Quarterly loss: $743 million

So what’s Elon Musk really saying?

“It took 15 years to execute on our initial goal to produce an affordable, long-range electric vehicle that can also be highly profitable. In the second half of 2018, we expect, for the first time in our history, to become both sustainably profitable and cash flow positive.”

-Tesla Q2 2018 Earnings Newsletter

Tesla is telling us that 2018 and the beginning of 2019 will look a lot like 2015 and the beginning of 2015 regarding free cash flow.

Tesla free cash flow.png

Source: Wall Street Journal

The premise here is that Tesla is built for volume, meaning it has legions of excess capacity, giving it massive amounts of operating leverage and economies of scale. A huge amount of the additional revenue from building new cars should fall to the bottom line under this scenario.

What Musk isn’t telling you, however, is how that statement reads from a risk perspective. He’s saying, “if we execute well, we will be profitable and cash flow positive,” couching these as attainable targets. The risk version of that statement is, “if we don’t execute well, we won’t scale. And then we will continue to be unprofitable. Free cash flow will be negative. And we will run out of money and default if we don’t raise more.”

Focus on the cash flow then

Should we use production targets as a proxy for cash flow? Maybe. How much operating leverage Tesla has is debatable. We just don’t know how much incremental cost is associated with building more cars on scale.

At the same time, we do know that Tesla wants to build a massive factory in Shanghai. So, they are going to go to market to raise money no matter how you look at it. The question is whether they will do so in a favourable market climate or a negative one.

As I said in my last note on Tesla, “If Tesla doesn’t get that burn rate down, it is going to have funding problems. These next couple of quarters of earnings are critical for Tesla then. Amazon is a great historical parallel. But things won’t necessarily end for Tesla the way they did for Amazon.”

The good thing for Tesla is that the burn rate has come down. But that doesn’t diminish the significance of the next couple of quarters. If Tesla doesn’t deliver results, you should expect a big selloff in its shares and its bonds. At this point, cash flow is all that matters.

One last point: operating leverage is a double-edged sword. As the economy expands, economies of scale increase operating margins. But when the economy turns down and sales volume declines, that leverage is vicious in slashing margins too.

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