The Challenges To Tesla Motors Inc.'s Model 3 Production Ramp

  • Tesla's 325k units pre-sale figure of the Model 3 supports my bullish investment thesis.
  • The level of investment required to ramp production to match 1,000,000+ in annual volumes is prohibitive on a cash flow/earnings basis.
  • I anticipate the company to raise debt to expand battery production capacity, which will put TSLA in a sustained investment phase.

Given the initial demand, Tesla (NASDAQ:TSLA) may need to ramp-up its Cap-Ex to match the level of interest. I don’t anticipate a dilutive event for shareholders in the form of a secondary share offering, as Tesla’s pre-order figures seem sound enough for many of the commercial and industrial (C&I) lending segments at some of the large banks to underwrite a secured credit facility (many banks have shifted asset mix to C&I over consumer lending in the past couple years).

Also read: Profitability Looming For Tesla Motors Inc. As Model 3 Orders Top 325k

That being the case, the narrative from investors has been the concern over excessive capacity in Tesla's Gigafactory and Fremont facility. I think the conversation will now shift to the incremental investment needed to match demand ahead of 2017 and 2018. Obviously, building incremental capacity takes years, and the company can’t miss the opportunity to ramp sales at a quicker pace. Competition is picking up in the space, and each additional car sold means the ability for more R&D and Cap-ex dollars down the road.

As such, I anticipate that any incremental investment into new capacity will negatively affect Tesla’s FCF. Furthermore, many will use the argument of added leverage or the heightened depreciation and amortization schedule as a basis for selling the stock.

Now obviously this is just the gimmicky nature of GAAP accounting. Usually, these asset/liability ratios and free cash flow metrics make a lot of sense for fully mature businesses. But, given the capital intensive nature of Tesla’s business model, there’s no denying that the heightened cost of meeting demand will also reflect poorly on Tesla’s near term P&L, balance sheet and cash flow statements. This is the part you really have to be watchful for, because many have used this counter argument for investing in companies undergoing a rapid investment phase. I would know because I’m usually on the receiving end of criticism when I make recommendations on companies like Netflix and Amazon (who are in the same boat as Tesla Motors).

But make no mistake, the risk to reward favors investors given the projected demand. I also believe that the return on capital far outweighs the perceived risk to investors, as Tesla’s dominance in battery supply puts them in a relatively solid position to ramp its pre-existing supply chain thus lowering the average cost of production via even greater economies of scale. Analysts are conservative, but reasonable on near-term estimates as sales growth will be heavily concentrated in the Model 3 line, and not in the S, X line-up.

As such, I don’t anticipate any near-term surprises on FCF or adjusted EPS metrics, as the company’s investment phase will likely pick up, thus diminishing improvement to profitability.

So, if there are bottom line shifts to the downside don’t be surprised, you have been forewarned.

The real cost comes from the capacity gains that Tesla would need to develop in the final phases of building out its current Gigafactory. The cost was pegged at around $5 billion for the plant, so an incremental capacity improvement to 1 million annual units would imply that Tesla’s CapEx would need to double to meet order requirements that exceed 500k. Obviously, the company’s estimates of 500k annual shipments was flawed, because the auto market is also growing and is expected to reach 111 million shipments by 2020.

Therefore, assuming market penetration of 1 million units/annum at a price point of $35k really isn’t farfetched at all, even though some may argue that subsidies are driving demand in the front-end of the launch. The pricing/features of the Model 3 are superior to other BEVs (battery electric vehicles) and are also comparable to high-end ICVs (internal combustion vehicles). As such, the positioning of the category and initial demand points to a protracted investment period.

In other words, having a decent level of success was going to be problematic for investors, but an excessive level of demand introduces a different reality for buy side/sell side analysts. Like I have stated earlier, I’m not yet finished with modeling out my assumptions on the cost structure as my amortization schedule and timing of sales is going to differ considerably from current street estimates.

Furthermore, the CapEx will remain heavily concentrated in battery capacity improvements because even if Tesla doesn’t reach shipments of 1 million per year, excess capacity could be sold to other automakers. So, there’s no perceived risk of downside from the perspective of Tesla’s management.

In other words, if you thought the cash burn was going to be bad at $5.5 billion to $6 billion in Capex cumulatively through FY’14 to FY’17, just wait until Tesla unveils to investors that Cap-ex will ramp even quicker to a tune of $9 to $10 billion over the next 36-months. That’s when you start running into a situation where the firm could actually report negative free cash flow to the tune of -$2.5 billion in FY’17 and FY’18. That’s roughly a doubling of current sell sides estimates of negative FCF, assuming sales for the Model S and Model X ramp at the current rate.

Of course, this is a more hypothetical scenario that has yet to materialize. But, an excessive level of success can only point to further investment. At the front-end, the cash burn will be big, but the impact on the balance sheet won’t be as bad, because it’s borrowed cash being converted into an asset. It’s the depreciation and amortization schedule that will make financial comps difficult to compare, as I can imagine depreciation expenses also doubling in response to increased capacity investments. I haven’t fully modeled out my assumptions, but this next phase to Tesla’s chapter is more promising but more convoluted for financial analysts.

Furthermore, I could imagine heightened uncertainty in the macro economy going into the 2018 to 2020 time frame. Remember, all economies are cyclical in nature, and while I haven’t found convincing data pointing to a recession in the immediate time frame, it’s worth noting that recession possibilities increase as we further elongate the length of an expansionary cycle. As such, Tesla investors face risks in the form of expectations on cost, and uncertainties in broad market sentiment despite strengthening fundamentals. I say “strengthening fundamentals” despite impending weakness in profitability metrics, because I believe each incremental Model 3 unit does more to increase shareholder value than the perceived risk of insolvency. i.e. even if Tesla’s FCF/EBIT metrics were to worsen, the incremental value of selling more vehicles at the long-end of a financial model asserts a better value case than curtailing investment to maintain acceptable financial metrics/ratios.

Therefore, buying Tesla will require investors to stretch their imagination beyond conventional financial metrics. It’s not that I’m against Tesla as an investment, it just so happens that heightened success will also come in the form of heightened costs. These heightened costs will not be well received by the investor base, but will be rationalized due to continued pre-sale volumes exceeding current capacity build out. Since markets aren’t always rational, it’s worth noting that volatility will remain heightened over the next two years despite the successful pre-launch of the Model 3.

However, stocks tend to be valued by the perceived value of future earnings/cash outflows, so I anticipate that investors will readjust to a more aggressive cost ramp despite weakness in near-term fundamentals.

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Comments on this article and TSLA stock

I didn't see any mention of powerwall sales #'s factoring into the value... Was it? If no, what woud the amended position be, or would there be no change?
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