Montana Skeptic


My title today alludes to a favorite Keats poem, On First Looking Into Chapman’s Homer. The Keats work is a sparkling sonnet, famously dashed off in a flash of inspiration, describing Keats’ excitement at coming upon the translations by a long-dead Elizabethan playwright of The Iliad and The Odyssey. The poem describes how Chapman’s earthy and sturdy verse gave Keats a far more vital view of Homer’s world than had other translations.

(I once read an account of someone who, seeing the title of the Keats poem, imagined for a glorious moment that the topic was baseball. To that reader, the title summoned up the image of the poet, having reached on a scratch single, standing on first base when the celebrated power hitter, Chapman, stepped to the plate, connected solidly, and launched a drive into the right field upper deck. In other words, this time inserting the necessary comma, On First, Looking Into Chapman’s Homer.)

Anyway, from the sonnet:

Then felt I like some watcher of the skies

When a new planet swims into his ken;

I had something of the same feeling of epiphany upon reading the latest Tesla (TSLA) 10-K, albeit with more dismay than excitement. I discovered that an SEC filing can fully illustrate how parlous are a company’s financial affairs and business model, but if the company’s stock has become a retail religion, with a share price fed by a buying frenzy that’s a clear instance of financial market mania, it simply doesn’t matter.

It matters so little, in fact, that several acquaintances emphatically counseled me not to bother writing this article. But I did. And so, while aware that Tesla’s share price is wholly untethered from business realities, I offer the following as the features of the 10-K that struck me most forcefully.

The Obvious Things

I’m not going to mention the obvious things about Tesla’s Q4 performance, presented in its Quarterly Update and then amplified in the 10-K, because others already have done a terrific job of that, including The Wall Street Journal’s Charley Grant and Bloomberg’s Liam Denning.

Instead, I’ll simply reprint this chart from Denning, showing Tesla’s trailing four-quarter revenue and GAAP net income:

Does that look like a growth company to you?

Coronavirus Disruption: Supply and Demand
I’m no epidemiologist, and I have nothing approaching an informed opinion about the severity of the coronavirus, about which expert views vary widely, largely because of the extraordinary sensitivity of the models. (By the way, guess which world-renowned virologist is among the experts?)

However, it’s clear that many automakers rely on parts from Chinese vendors and are now facing manufacturing disruption. Hyundai and its sister company, Kia, were forced to idle their plants for several days, and other large auto companies fear imminent parts shortages.

Tesla is among those relying on China-made parts, both for the cars it builds in Fremont and, especially, for the Model 3s it builds in Shanghai. Tesla’s Shanghai production is heavily reliant not only on Chinese parts, but also on Chinese labor. One of the factors Tesla has claimed will allow it to cut production costs in China is reducing reliance on automation while increasing use of inexpensive manual labor.

Moreover, Tesla’s Shanghai factory obviously is relying on Chinese consumer demand to snap up its Model 3 production. Even before the Corona Virus entered the news, Chinese consumer demand for automobiles was problematic, with 2019 sales dropping by 7.4% relative to 2018. And the EV market was much softer than the overall auto market.

Tesla made no mention of the virus in its Q4 Quarterly Update, published on Jan. 29. To the contrary, all was well:

Model 3 production in Shanghai is continuing to ramp while Model Y production in Shanghai will begin in 2021.

Tesla executives mentioned the virus during the earnings call in prepared remarks, but downplayed any material consequences. Per Chief Financial Officer Zachary Kirkhorn:

At this point, we’re expecting a 1 to 1.5 week delay in the ramp of Shanghai built Model 3 due to a government-required factory shutdown. This may slightly impact profitability for the quarter, but is limited as the profit contribution from Model 3 Shanghai remains in the early stages. We are also closely monitoring whether there will be interruptions in the supply chain for cars built in Fremont. So far, we’re not aware of anything material, but it’s important to caveat that this is an evolving story. However, we have more than sufficient cash to continue our expansion plans, while further strengthening the balance sheet.

The 10-K, however, published two weeks later, used more bracing language:

It is unknown whether and how global supply chains, particularly for automotive parts, may be affected if such an epidemic persists for an extended period of time. We may incur expenses or delays relating to such events outside of our control, which could have a material adverse impact on our business, operating results and financial condition.

As appears in the 10-K caution, Tesla may be facing production disruptions in both Fremont and Shanghai. Tesla’s Shanghai factory is back in operation, but there are no confirmed reports of what volume of production it is achieving. And, of course, no reports at all about the level of Chinese sales.

Per @phoennix10 at Twitter, who is familiar with the Chinese auto parts market, some of Tesla’s parts suppliers are in areas under quarantine. Also, at least some of Tesla’s labor force is from those same areas, and it’s possible if not likely that some factory workers were hindered in their return to Shanghai after the Chinese New Year.

A further phoenix feeling: As the Chinese parts suppliers swing back into production, Tesla will not be high on their priority list, other larger, better-established customers will come first. I reserve judgment on that point; if for whatever reason the Chinese government cares a lot about Tesla (and it appears to care a great deal), then Tesla may become a mandated priority).

The China demand picture should worry Tesla investors even more than the China supply picture. This, the sobering latest, from what’s regarded as an official Communist Chinese Party news organ:

I went into 2020 expecting Tesla would have a GAAP loss of between $500 million to $800 million in the first half of the year, and would end the year with (once again, keeping the perfect streak alive) a GAAP loss. The news out of China suggests the financial results may be worse than I had forecast.

Of course, other automakers face similar disruptions and financial stress. None of the others, though, is trading at Tesla’s impossible metrics. (Pick any metric: Price to earnings, price to book, EV to EBITDA, etc.) Not that it matters right now, but I repeat myself.

Einhorn Has His Answer

David Einhorn and Elon Musk got into a celebrated scrap last year; key parts of the exchange can be read here and here. During the exchange, Einhorn asked Musk to explain the $1 billion accounts receivable figure on the Q3 balance sheet:

(from an open letter from Einhorn to Musk)

Despite several reminders, Musk never answered Einhorn’s question. Meanwhile, the accounts receivable figure in the year-end balance sheet ballooned further, to $1.324 billion. What’s going on here? The 10-K furnishes our answer:

Accounts receivable primarily include amounts related to receivables from financial institutions and leasing companies offering various financing products to our customers, sales of energy generation and storage products, sales of regulatory credits to other automotive manufacturers and maintenance services on vehicles owned by leasing companies.

Tesla achieved many of its Q3 and Q4 deliveries by making fleet sales to third parties at discounts and allowing the buyers to pay only once they had unloaded the goods to the end users. In some instances, it appears Tesla is offering generous residual value guarantees to get the deals done.

We offer resale value guarantees or similar buy-back terms to certain international customers who purchase vehicles and who finance their vehicles through one of our specified commercial banking partners. We also offer resale value guarantees in connection with automotive sales to certain leasing partners. Under these programs, we receive full payment for the vehicle sales price at the time of delivery and our counterparty has the option of selling their vehicle back to us during the guarantee period, which currently is generally at the end of the term of the applicable loan or financing program, for a pre-determined resale value.

I trust it’s now clear why Musk so resolutely declined to answer Einhorn’s politely posed question.

Again, this seems terribly bearish for the stock. In effect, Tesla has engaged in some massive channel stuffing to get deals done.

Alas, the chickens do eventually come home to roost. We have nearly current registration reports from three European countries, Norway, The Netherlands, and Spain. Norway has traditionally been Tesla’s largest European market, though it was eclipsed in Q4 by The Netherlands where tax incentives pulled sales forward.

Take a look at how, so far, cumulative Tesla deliveries in Q1 (the red line) stack up against Q4 (the gold):

Sure, there’s still a lot of wood to chop in Q1, and Tesla famously manages to jam most of each quarter’s sales into the final month. Still, in the two vital markets of Norway and The Netherlands (and in the less important market of Spain), the Q1 picture is challenging, to say the least.

Several commenters here insist Tesla will rescue Q1 and Q2 by focusing on the United Kingdom (where significant EV incentives exist) and South Korea (same), in much the same way that The Netherlands rescued Q4. I don’t doubt that will happen to some extent, particularly if Tesla again resorts to fleet sales.

However, this year Tesla faces increasing and formidable competition. In Q1, Tesla is not even among the top seven EV brands in either Norway, The Netherlands, or Spain. (As for the rest of Europe, we do not yet have reliable reporting, but I expect similar results.) Increasing the Q1 delivery number will require cutting prices, offering residual value guarantees, offering other incentives, or some combination of those.

Indeed, in the United Kingdom, Tesla already has had to slash its leasing terms:

A screenshot of a cell phone Description automatically generated

(From Seeking Alpha’s jaberwock, who also posts at Twitter)

It just might be that those who are confident the UK and South Korea will ride to Tesla’s rescue this year are in for an unpleasant surprise.

(But, of course, right now it doesn’t matter. Nothing Matters. Until…)

The Curious Silence about Model Y Demand
Tesla’s earnings release boasted that the “Model Y production ramp started in January 2020, ahead of schedule,” and featured several photos of the Model Y in production:

The 10-K expanded on the Model Y news:

Model Y is a compact sport utility vehicle (“SUV”) built on the Model 3 platform with the capability for seating for up to seven adults, which we began producing in January 2020 and expect to commence delivering in the first quarter of 2020. We currently manufacture Model Y at the Fremont Factory, and are further ramping production there and making preparations for production next at Gigafactory Shanghai. We currently offer Model Y in dual motor all-wheel drive Long Range and Performance versions.

The 10-K added this note about the Model Y in Shanghai:

We have also commenced construction of the next phase of Gigafactory Shanghai to add Model Y manufacturing capacity at least equivalent to that for Model 3.

Tesla claims its capacity in Shanghai is 150,000 Model 3s per year, so it’s promising an added capacity of as many Model Y cars, though it’s silent about when Model Y production in China will commence.

What remains absent from both the Quarterly Update and the 10-K? Any indication of the number of orders Tesla has received for the Model Y. After all the boasting Musk did on Twitter about the number of Model 3 orders, the silence here is deafening.

I have four beliefs about the Model Y:

First, Tesla accelerated production of the Model Y because it realizes demand for the Model 3 already is waning. Every Model Y made in Fremont is a Model 3 that won’t be made.

Second, Tesla has been tight-lipped about the Model Y order book because it has so few orders that publicizing the number would be embarrassing.

Third, while the Model Y undoubtedly will find buyers at the outset, after a quarter or two of production, it will be evident that the Model Y is cannibalizing Model 3 sales.

Fourth, the Model Y’s introduction, especially in Europe and Asia, will be quite different from the Model 3’s introduction. The Model Y will face much more competition than did the Model 3 in both those markets.

Your beliefs may vary.

Goodwill v. Warranty: No Questions, So No Answers

In collaboration with Twitter’s @orthereaboot, I wrote two months ago about how Tesla appears to be charging to goodwill many costs that ought more properly to be categorized as warranty, and how this practice has the effect of inflating both gross margins and reported net income.

Since that article, evidence that such mis-categorization is regularly occurring continues to accumulate:

I had hoped someone would question Tesla about this during the earnings call. That, of course, was a vain hope. The word “warranty” was never even mentioned.

(Also absent from the 10-K: the word “robotaxi,” of which last April we were promised a million or so this year.)

Meanwhile, as evidenced by data in the 10-K, assembled for me by Twitter’s valuable @Badger24, (whose profile – “Tree-huggin, peace-lovin, pot-smokin, porn-watchin, lazy-ass hippie” – is taken from a Todd Snider song), Tesla actually reduced its warranty reserve per vehicle in Q4:

By the way, @orthereaboot has a great rundown of some notable 10-K features, which you can find here.

And also by the way, peace-lovin’ Badger, who in his day has reviewed thousands of 10-Ks, offered me a succinct and insightful view of Tesla’s:

This one stands out as exceptionally devoid of projections and any sort of comprehensive review of business drivers and results, especially given the size and complexity of the company. I’ve seen similar detail-starved Ks, but they were for tiny companies with simple manufacturing businesses and less than $50 million of annual sales.

It’s stunning not to see any formal numerical guidance whatsoever, beyond a 40% range for capital expenditures ($2.5 billion to $3.5 billion). No delivery guidance, no margin guidance, no profitability guidance. And somehow this company sports a $170 billion market cap. All the things that should matter, don’t any more.

I still feel like I’m sitting on the trump card; let’s see how Tesla does in an economic downturn. In the meantime, I just have to shake my head because I lack the suspension of disbelief necessary to conclude Tesla has anything resembling a sustainable business.

Thanks for sharing, Badge.

Author: Montana Skeptic

Source: Seeking Alpha: On First Looking Into Tesla’s 10-K

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