Tesla Stock Still Remains A Buy

  • Tesla changed their production timeline, which has caused jitters following the report.
  • I believe the accelerated timeline is attainable, but changes in the process will be required.
  • Tesla stock still looks appealing despite the recent drop.

In line with my earlier commentary with regards to Tesla (NSDQ:TSLA), the company did indeed increase its production target and planned to increase CapEx by roughly 50%, which is higher than the prior outlook. I figured the stock wouldn’t perform well following the report, as it has become more and more clear that Tesla is in a longer term capital deployment phase.

Notwithstanding the changes in cash flow/net income assumptions, I believe the investor base will start to re-acclimate despite the diminishing possibility of GAAP profitability over an immediate two to three-year window. Other business cases, i.e. Amazon shows general leniency towards sustained investment even if FCF metrics turns negative for a certain number of years. Instead, the metric to watch for is growth, order backlog and the supply side execution as we progress through quarters.

I think the concern among the consensus is execution risk, but the bigger risk to analyst models is the level of investment that’s likely to pile on top of the initial 50% growth in CapEx given the rapid expansion of the total addressable market (TAM) for battery electric vehicles (BEV). Furthermore, I believe the issue of total cost of ownership (TCO) and whether lifetime savings from a BEV could be competitive with internal combustion vehicles (ICVs) will abate as we progress through the next five years.

I believe oil prices will recover quite significantly over the timeframe despite 2020 oil future contracts trading at appx. $54 to $55 (which is where a lot of analysts are plugging some of their future value assumptions on oil prices). However, longer-dated oil futures are generally non-indicative of pricing, as the entire curve tends to shift in response to shorter-duration pricing movements. Given what I know, demand for larger vehicles, resurging emerging markets growth and supply curve readjustments are inevitable given the unit economics and the combined geopolitical bias towards eventual lower volumes. As such, I believe BEVs will create a far more compelling case as we move through the current cycle, which will take several years to materialize, but revisiting oil prices above $100/bbl seems inevitable given factors like inflation, demand and historical oil producer behavior despite better break-even for unconventional resources.

Here's some analyst commentary about production and timing of CapEx:

Clearly, the most important development from Tesla’s Q1 call was that this company intends to significantly steepen their growth plan. Tesla now targets 500,000 units of annual production by 2018, 2 years earlier than previously planned. And while there are plenty of execution risk associated with this unprecedented growth plan (For example TSLA has not yet finalized design and engineering specs, which implies a very tight timetable for supplier contracting, part development, and validation), the company emphasized that they’re adopting a change in strategy w/r/t design and engineering risk. – Rod Lache from Deutsche Bank

“If you build it, they will come” type position, we still see significant obstacles to ramping production as quickly as Tesla had previously envisioned — and particularly as relates to this new envisaging. We caution investors against incorporating the new guidance into their base case scenario in modeling either earnings or valuation. – Ryan Brinkman from J.P. Morgan

In our view, the move to build out additional capacity and accelerate production makes sense given the high reservations but does not alleviate the degree of difficulty of launching a high volume product. The average gap between unveiling and production at Tesla has been 3.5 years, making the planned Model 3 timing (a gap of 1.75 years) already onerous, before addressing the ramp. – Patrick Archambault from Goldman Sachs

That being the case, Tesla’s commentary coming out of the quarter was a bit mixed. Near term production ramp of the Tesla Model X/S seems to be on track again despite the Q1’16 hiccup. Production comes online in a sort of s-curve, which is an exponential curve followed by a logarithm over the course of a factories life. With continued investment in production, the exponential part of the curve will sustain for a multi-year duration as incremental production facilities come online, which sustains high levels of CAGR. The math makes sense, but the expert commentary about the ramp-up of production is hard to encapsulate fully, as the management team and many of the analysts are on polarizing spectrums.

Here’s what Elon Musk mentioned on the earnings conference call:

Overall, on the short-term stuff, our quarter-over-quarter stuff I think has improved quite significantly. I've seen Model X production increase by a factor of five from Q4 to Q1, and we continue to make huge strides in volume and quality of the vehicle. And I'm personally spending an enormous amount of time on the production line. And with the increase in ramp, we do feel comfortable affirming the 89,000 deliveries this year. Now, will we actually be able to achieve volume production on July 1 next year? Of course, not. The reason is that even if 99% of the internally produced items and supplier items are available on July 1, we still cannot produce the car because you cannot produce a car that is missing 1% of its component.

Realistically July 1st, 2017 is a bit unrealistic, but many of the components will be in place. I believe the batteries will reach the targeted timeframe whereas smaller components will take longer to reach production lines. Even so, the timeframe for mass production ramp is Q4’17 with annual output likely to reach 500,000 units towards the second half of FY’18. To reach production targets, I’m anticipating Tesla to progress with production with unfinished stockpiles of cars and once missing components reach assembly the company will go back and retrofit the remaining components into the cars. I believe the mechanical components and battery packs become more predictable given pre-existing sourcing capabilities and usage of some industry standard parts.

I believe Tesla will look to lease storage facilities for nearly completed yet unfinished Model 3’s. Yes, I know this sounds somewhat ridiculous as it implies higher inventory levels, and generally speaking, the supply chain is meant to operate on lowest possible days inventory turnover. However, given the unprecedented nature of timing production and the need to implement alternative solutions, it’s more likely that the solution to the problem is to stack up as much near unfinished goods and then quickly fit the remaining components and sell the finished product to consumers.

Some of the smaller nittier grittier items like electronic equipment for 1st generation autonomous functionality will take longer to hit the production chain given the timing of semiconductor fab tape outs and validation. My research into autonomous driving assistance systems points to this as being the highest likely candidate for slower roll out. Since the MCUs (microcontroller units) and MEMs (microelectromechanical systems) will take longer, it’s possible for Tesla to work out the mechanical components and retrofit the remaining electronic components into the car, which will make production lumpier.

However, fabs become ridiculously efficient once initial wafer volumes are met and yields are optimized. Since Tesla has been in the design phase for key hardware components for quite a while now, I believe the timing of these semiconductor components will reach production lines roughly a quarter following the deadline. Even the most aggressive timeline assumes sampling in Q2’17 and production of semiconductors in Q3’17. Since half a million is considered low-volume, it becomes more difficult to reach acceptable yields and validate the reliability of semiconductor components. Since the silicon goes into critical driver systems, the testing phase will likely protract, as such I still view the 500,000 timeline attainable, but it’s going to be back half 2018 loaded with deliveries in Q1’18/Q2’18 likely less than half with more than half reaching consumers in 2H’18.

I continue to reiterate my buy recommendation on Tesla and will follow-up with projections on sales/earnings in the immediate article following this.

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