Description

SolarCity Note.  The following analysis does not factor in the SolarCity merger announcement yesterday (which is discussed at bottom.)  However, net/net, the SolarCity announcement appears to be an incremental positive for Tesla short-sellers.  (Simply, there is one more thing that can go wrong.)

Context.  I am a big fan of Elon Musk and am enthusiastic about the vehicles that he is creating.  I may even buy a Tesla someday.  Mr. Musk is ambitious, and he's been very successful to date.  However, his current plans are very aggressive, and there is a wide range of potential outcomes.  The current stock-price seems to reflect an overly optimistic view of the likely near-term scenarios.  There are a number of things that can go wrong -- and even if things go remarkably well, much of that success may be reflected in the current stock price.

Background: What does Tesla currently produce?  Currently Tesla produces two main vehicles, the model S (sedan) and model X (SUV).  2015 combined sales were roughly 50K units.  Given revenues of $3.74B, ASP was roughly $75K/unit.  Gross margins have been improving; they were 18% in Q4, although Musk states in the Shareholder Letter that he believes Model S gross margins can be "tracking toward" 30% by Q4 2016.  (That's an increase from Q4 gross margins of ~$13.5K up to $22K, which would be a solid improvement.)  If we omit the "services" business, we can estimate the "auto" business as $900M of gross profit vs. $1.5B of operating expenses, producing EBIT of ($600M).  

What does a "good outcome" look like?  Pre-orders for the Model 3 are currently somewhere north of 350K.  Let's assume that Tesla launches the Model 3 by late 2017 (a tall order), and by late 2018, they've delivered 300K units (a very ambitious rollout.)  Let's further assume that they maintain their existing sales volumes for the S and the X.  Further, let’s assume that they accomplish all this while making substantial profitability improvements.

So Tesla maintains $3.75B in revenues (from the S and X), and they add incremental revenue from 300K Model 3 sales at $40K each -- another $12B.  Moreover, let’s assume that they get to 30% gross margin for the S and X, and 25% gross margin for the Model 3.  All told, Tesla would be at $15.75B revenues and $4.1B gross profit -- a dramatic expansion from today's numbers.  That 600% growth would mean that Tesla sales had reached the equivalent of more than ~2% of new US auto sales (based on SAAR of ~17M).  

Let's further assume that Tesla only grows its overhead by 2x, despite this dramatic growth in unit sales.  So they've got $3B of operating expenses (twice today’s level), which (based on $4B of revenue) provides EBIT of $1.1B.  Using 2015's (favorable) interest expense of ~$120M, that leaves $890M of pretax profit, and at a "normalized" tax rate of 35%, Tesla earns ~$580M of net income.  Currently there are ~130M shares outstanding, so that's about $4.45/share.  

What's a reasonable ceiling?  "Yes", some may say, "$4.45/share by YE2018 is not so great, but Tesla will keep growing -- so they'll command a huge multiple."  But today's price of $196/share seems like a pretty large multiple (44x) of that "good outcome" ($4.45/share) for an auto manufacturer.  (Even if Tesla revolutionizes the market and earns $5 or $6/share by 2018 (seems unlikely), one might expect the multiple to compress as other automakers begin rolling out competitive offerings).  

Risk: it's possible that Tesla becomes the "iPhone" of the auto industry and continues to ramp its market share beyond the 300K unit "Model 3" rollout.  (But what seems MORE likely is that meeting these ambitious goals proves to be challenging).

Short Case:  Current expectations for Tesla appear to be very high, and their targets appear very aggressive.  A variety of things could go wrong, resulting in negative headlines, failures to deliver, reduced revenues, added costs, and less of a “head start” vs. competition.  And these developments can be expected to depress the stock price.  

What could go wrong with production?

• True demand may be less than 300K units.  Tesla wasn't initially "expecting" this level of demand (reportedly at least 2-4x company projections), and anecdotally, some of the people I know who put down deposits aren't particularly serious about it.  (Specifically, three of my friends made the deposit without telling their wives, and they said there's a "less than 50% chance" that they ultimately make the purchase.)  So perhaps some of the 300K+ demand is “phantom” (not real) demand.

• Tesla may find warranty / reliability issues with existing production.  These may be addressed/redesigned before pushing the new model to production.  There are plenty of indications of reliability issues on their recent production.  Fixing those issues could require engineering resources, or the reliability issues of past (expensive!) cars could require design changes for the Model 3.

• The rush to design and produce the new model may result in delays or high costs.  There is a track record here.  Musk has overpromised in the past.  Tesla models have had past delays… And the currently planned rollout is ambitious by any standard.  With Musk “sleeping at the factory” to work on developing the new production line, it’s clear that the current goals are at least somewhat of a “reach.”  Recall that current lines, once at full production capacity, would produce only ~80K cars/year. 

• Issues with existing production could hurt Tesla reputation / brand.  Potential issues discussed above could hurt Tesla’s reputation or reduce consumer demand.  If the massive pre-order volume reflected an unprecedented enthusiasm for a new car, then even moderately negative consumer reviews could substantially depress this demand.

• The departure of key staff could prove problematic for producing the new model.  Five Tesla VPs, including two production chiefs, have left in the past 4 months.  At a time with the company is in rapid expansion / all-hands-on-deck mode, replacing these executives (and getting new executives up to speed) may be disruptive.

• Supply chain may be unable to meet required targets.  Even if Tesla pulls off IT’S end of the bargain, it may find that suppliers – many of whom book out orders 2-3 years in advance – are unable to ramp production to meet scheduled deliveries.  The industry’s long history of supply chain issues  (and the current lean nature of the supply chain) suggests that Tesla should be wary of ripple effects from overly-stretched suppliers.
  
  
• Tesla – even if they hit all their production targets – may not do so profitably.  Even if margins improve, making the dramatic margin improvements that Musk is targeting looks to be a tall order.  And given the revolutionary vehicle that they are building, and the pace of production, it would be unsurprising if the costs to deliver on this plan were relatively high. 

Summary: In short, Tesla has set very ambitious targets that (1) until recently, they weren’t planning to hit, (2) they don’t have a history of meeting, (3) are based on a “forecast” of consumer demand that may be more fickle than it appears, and (4) require dramatic improvements in profitability (while delivering a revolutionary vehicle on a compressed schedule).  Although it is clear that Tesla’s targets are aggressive, the current stock price seems to “bake in” relatively favorable results.  Any number of negative events could prove favorable to short-sellers.

Additional note re: the SolarCity Merger: The negative market reaction to the SolarCity deal (and the commentary from Jim Chanos) is sufficient to demonstrate that this development is not a “positive” for Tesla.  It was certainly a “positive” for SolarCity, whose bonds were yielding 20%.  But if the merger goes through and SolarCity continues to struggle, that may be a drag on the Tesla stock (or a distraction for management).  It is hard to argue that the deal is a “good one” for Tesla…  If they wanted to “cooperate” and “cross-market” with SolarCity, there are alternative agreements that would enable such collaboration without a full-blown merger.

Catalyst

Model 3 Delivery Goals (Production Volumes, Timelines, Margins)