"Tesla. A Much Needed Reality Check (in depth)" - Julian Cox's Expert Analysis Posted

[bonnie]

These forums are rife with gushing praise of mr. Cox's expertise, and more than a handful of forum members are clearly taken enough with his analytic prowess that they are committing real dollars to his conclusions. This is a shame.

i will endeavor to point out the basic flaws in his analysis with more empathy in the future.

Not asking for empathy, that's up to you. I'm only asking that people state their opinion without unnecessary putdown of other forum members. You could have said exactly the same thing without making it personal. Of course, I don't need to point that out to you. You were well aware of what you were doing.

 

[PeterJA]

i will endeavor to point out the basic flaws in his analysis with more empathy in the future.

I appreciate hearing the flaws in any analysis, presented with or without empathy. But you haven't quite finished the job.

You have said that Tesla's cost of capital is not zero (as Julian claims) but you haven't said what it is. Can you please take a stab at that, so we can know whether the difference between your number and his actually makes a significant difference in his conclusions?

 

[Julian Cox]

One more thing to note as I attempted to make clear in the article but perhaps not clear enough.

Correcting two data points in Damadaran's valuation model wipes out his model, but that does not magically convert it into a good model. It is riddled with flawed assumptions regarding rate of growth for example. If Tesla is able to compound growth at 100% annually until 2022 (and I believe it is incumbent on the naysayers to prove why that cannot be so, not Tesla to defend its current and actual rate of progress), 2022 production numbers will be in the order of 10 Million units or a 512 growth multiple. Not sixty as claimed by Damodaran. For sure, cash flow will not be an obstacle, and if not cash flow or technical/product leadership, then what exactly is the bear case besides "I can't believe it".

 

[FluxCap]

For sure, cash flow will not be an obstacle, and if not cash flow or technical/product leadership, then what exactly is the bear case besides "I can't believe it".

I'm pretty sure that is the crux of the most "popular" bear cases I have read. I have yet to see a valid case for extensive near to medium-term cash needs at Tesla Motors, at all, and I completely agree that valuations based on the assumption that Tesla will need to raise significant capital in the future (or really, at all) are tenuous at best. Yet this is the focus of so very much criticism.

What boggles my mind is that there actually are quite a few valid risk concerns for Tesla Motors that could be addressed in analysis that are being subjugated to flawed analysis of the business model (such as Mr. Damodaran's). In particular, I see risk of management execution and the concentration of so much managerial talent in one man as by far the biggest risk for Tesla going forward. If I got a question on the conference call, I would want to dig into how he intends to scale the company from a management and personnel standpoint and further delegate his responsibilities so that he is not stretched too thin, and can maintain control while focusing on the most important tasks in his day. I will grant that Elon already has a fantastic track record in attracting and retaining top talent (this weeks hire of Apple exec Doug Field is a case in point), but I'd like to hear Elon discuss this in greater detail on the conference call.

For a production-constrained company that has unparallelled demand for its products in the industry, I also don't see the need for larger marketing expenditures. Eventually though (with the GenIII) I think marketing and ad spending could more important as the mass product gains traction. Then again, there might be waiting lists and lines around the proverbial block iPhone-style. We shall see!

Thanks Julian for chiming in here, and thanks for your continued sharing of your excellent analytical modeling.

Cheers,
Flux

 

[ModelS8794]

ModelS8794. I am not persuaded that your remarks are useful. I believe you are confusing the cost of capital from an investor's perspective with the cost of capital as seen from the business. From the business side we were looking at dilution and the cost of servicing debt. This is the function of cost of capital used in Damodoran's spreadsheet and precisely the one I have chosen to correct. I do not believe Tesla needs to sell equity or purchase debt in 2014 through 2018. I believe the businesses Tesla is often compared with for the purposes of modelling would do, hence the difference in value. I do not believe the distinction is sufficiently well appreciated and much effort has been put into obscuring that difference out of either ignorance or the desire to profit from the ignorance of others.

You are incorrect. the model uses cost of capital to establish the discount rate. the adjustment you make reduces the discount rate to 0, which is why 65 becomes 200. You are therefore concluding that a dollar of profits earned is worth a dollar today, regardless of whether it is earned in 2013 or when Tesla establishes their Mars headquarters. I don't think you did that purposely, but if you do believe firms that generate all needed reinvestment capital organically have a zero cost of capital and deserve a zero discount rate, I suggest you broaden your horizons beyond Tesla because there are literally thousands of 10-baggers waiting for you to buy them atunreasonably cheap current values.

If you want to adjust a DCF to incorporate more generous assumptions around necessary reinvestment, then you should focus on his assumptions that drive ROIC and required reinvestment rates, not cost of capital. Take a look at the model again and think about the inputs a little more and I am sure you will see it.

 

[Palpatine]

Unlike Apple and unlike any other vehicle manufacturer approaching the scale of Tesla, Tesla’s core business is cash flow positive. Neither Tesla or its shareholders carry the cash risk to build inventory in anticipation of sales. Tesla’s books are devoid of any drain on working capital sunk into finished goods inventory more than a modest quantity of service loaners and demonstrators. Accordingly, the Tesla business model completely defies the capital constraints normally applicable to manufacturing, especially in the auto industry.

Julian, I don't think the auto industry functions as your believe. Auto manufacturers get paid right away by auto dealers. The cars that are building in inventory on auto lots "finished goods" are not carried on the books of any manufacturer.

There is about 1-4 weeks between finished production, shipment, then delivery to the customer. A car in production also likely takes a few days, so the cost of materials is already spent by Tesla. They likely do have 15-30 day terms from suppliers. But a safe margin of cash on hand to support monthly production of Model S, Model X and Gen III would likely be over $1.5 billion.

We are talking about a $15 billion annual sales revenue company at that point. They need more than one month of cash in the bank to support all of the elements of that scale of business.

 

[FluxCap]

Julian, I don't think the auto industry functions as your believe. Auto manufacturers get paid right away by auto dealers. The cars that are building in inventory on auto lots "finished goods" are not carried on the books of any manufacturer.

Payment by dealerships to manufacturers is not the same model. They still guess at their demand and then build cars before receiving end customer orders and cash, so they need to have cash (raise capital) to do this. Tesla takes orders, takes cash up front and then builds a car. This actually eliminates product warehousing and inventory completely. It also eliminates dealerships. There is no other auto company on the planet that could do this even if they wanted to because it is highly unlikely that anyone is going to preorder a gas-burner when they have no compelling reason to do so. The literally revolutionary Tesla product enables the revolutionary business model here, not the other way around.

 

[Palpatine]

Tesla doesn't collect 100% of the sales price up front. They collect about 3% of the cost up front via the $2,500 deposit. So there is a capital cost of production that Tesla carries on the books until full payment is made. I would argue that other auto manufacturers get paid by auto dealers just as fast as Tesla gets paid. Or the difference is so small as to be meaningless.

Dell was an amazing business model. They received 100% up front. You had your PC within a week, but Dell still had another 2-3 weeks before they owed their suppliers payment.

Tesla is likely going to plan for 300,000 cars per year by 2018-2020. A mix of 3 different car models. Likely an overall sales average of $50,000 to 60,000. That is over $15 billion in sales per year. I own a company involved in manufacturing, much smaller of course, but the cash needs are the same regardless. My guess is they will want to have at least 2-3 months of cash in the bank to manage through any rough spots. I think Tesla Motors will want to have cash in the bank of $3 billion to support a $15 billion revenue business.

Suppliers will only extend terms of 30 days if they feel that you are a safe credit risk. Part of that is your cash balance. Nobody would feel safe with a $15 billion revenue manufacturing company having only $1 billion in the bank. Just my opinion.

Will Tesla generate enough profit to build up to $2-3 billion in cash in the next 5 years? I don't know. They are projecting to plan towards cash flow neutral for the next few quarters as they scale for Model X. $100 million capex for Superchargers.

It is tough to envision cash building on the balance sheet with so much capex to to scale up Superchargers, stores, service centers, manufacturing capacity, etc.

I don't think they need to raise capital in 2014. $700 million in the bank appears to be sufficient to support the current $2 billion in sales revenue. But by 2015 when they are planning for Gen III, I think Tesla will need another $1 billion capital raise either through debt or equity.

 

[FluxCap]

Tesla doesn't collect 100% of the sales price up front. They collect about 3% of the cost up front via the $2,500 deposit. So there is a capital cost of production that Tesla carries on the books until full payment is made.Dell was an amazing business model. They received 100% up front. You had your PC within a week, but Dell still had another 2-3 weeks before they owed their suppliers payment.

Agreed. There is as you say a cost of production beyond deposits received, but the order is known and the time needed to cover cash is enviably short and predictable. It can also be funded from deposits as long as suppliers have payment terms that are post final sale, which would be closer to the Dell model in which suppliers effectively become lenders.Cash is just not going to be a problem for Tesla, even if you build in future borrowing. Various models treat this differently but still miss the differences in Tesla's cashflow situation.

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Suppliers will only extend terms of 30 days if they feel that you are a safe credit risk. Part of that is your cash balance. Nobody would feel safe with a $15 billion manufacturing company having only $1 billion in the bank. Just my opinion.

I think this is where we disagree. Suppliers are going to ride Tesla sales to massive revenues, and I think their terms will be hugely favorable.

 

[ModelS8794]

I appreciate hearing the flaws in any analysis, presented with or without empathy. But you haven't quite finished the job.

You have said that Tesla's cost of capital is not zero (as Julian claims) but you haven't said what it is. Can you please take a stab at that, so we can know whether the difference between your number and his actually makes a significant difference in his conclusions?

PeterJA, the issue isn't a matter of differing opinion on Tesla's appropriate cost of capital. The issue is the analysis under discussion starts with a false premise (retained earnings carry no attendant cost when reinvested into a business), and compounds the error by reaching conclusions (Tesla's discount rate = 0) that don't even have anything to do with the starting assumptions. The real irony of it is it appears Mr. Cox doesn't even realize that's what he's done.

Some of my opinion on Damodaran's model can be found here and here. I don't think they are particularly material, though. I certainly wouldn't take any action using them as a basis.

 

[Julian Cox]

Julian, I don't think the auto industry functions as your believe. Auto manufacturers get paid right away by auto dealers. The cars that are building in inventory on auto lots "finished goods" are not carried on the books of any manufacturer.

There is about 1-4 weeks between finished production, shipment, then delivery to the customer. A car in production also likely takes a few days, so the cost of materials is already spent by Tesla. They likely do have 15-30 day terms from suppliers. But a safe margin of cash on hand to support monthly production of Model S, Model X and Gen III would likely be over $1.5 billion.

We are talking about a $15 billion annual sales revenue company at that point. They need more than one month of cash in the bank to support all of the elements of that scale of business.

One most compelling thing I have seen on this subject is the CCC (Cash Conversion Cycle) comparison done between Tesla and Ford by SA contributor 'Renim".

He calculated Ford at +175 days. i.e. Money out for 175 days before back in the bank with any profits made. Tesla -12 days. i.e. cash in the bank with profits 12 days in advance of expenditure.

Just from a common sense perspective, Ford et all build a whole field of cars, then these go to a load of selling lots and sit and wait for a buyer. It really does not matter who has to cash-flow all that capital inefficiency (Ford, Ford Credit, Dealer Network, Credit houses supporting Dealers etc). Nobody funds waste like that for free.

More to the point, when it comes to contemplating doubling the size of a business analogous to Ford, no wonder people wring their hands about the capital intensive nature of auto manufacturing because one way or another someone is either going to have to stump up the cash for a double sized field of cars or it isn't going to happen.

Because Tesla owns the entire end-to-end sales channel for its vehicles that matters in the case of Tesla is that Tesla does not have to sink any cash into that process at all, not now and not to double the size of the business repeatedly. In the case of Tesla Financing it also gets the finance introduction fee that would have gone to a dealer.

 

[Palpatine]

Just for rough comparison purposes, lets use Ford.

$142 billion in sales revenue
$26 billion in cash
$102 billion in debt

That includes all sorts of things like their finance division and other subsidiaries, so it is tough to make an apples to apples comparison.
But they clearly maintain enough cash in the bank to support 2 months of sales revenue.

GM
$152 billion in sales revenue
$24 billion in cash
$27 billion in debt

I recall when GM was near bankruptcy a few years ago, the reports were saying they would have to file if their cash fell below $10 billion. It just wasn't possible to support that scale of business with less cash in the bank to support the entire enterprise.

In both examples, cash in the bank is about 2 months of sales revenue.

I suspect that any company involved in serious manufacturing will face the same reality of healthy balance sheet to get reasonable terms from suppliers. If the cash falls too low, the suppliers will want payment in advance, no terms, which accelerates the death spiral into bankruptcy.

Tesla currently operates with a much safer balance sheet than Ford or GM.

$2 billion in sales revenue
$750 million in cash
$600 million in debt (convertible to equity)

I don't see a chance in heck that Tesla will scale up to 300,000 cars ($15 billion in sales revenue) without having to raise more money. Not with all of the CAPEX they have to spend in the next few years.

Having grown a company myself from nothing, I can say from experience, growing production capacity quickly with internally generated profits is tough. Even when profitable, it is typically not enough profits to double your production capacity on internal cash only.

Tesla is likely fine for the Model X with current cash. But my guess is that they raise another $1.5 billion in 2015 to fund expansion for Gen III. Raising $1.5 billion with a $20 billion market cap is easy. 7.5% dilution. They can do it and it is worthwhile. That is reasonable dilution to take advantage of the growth opportunity.

 

[PeterJA]

PeterJA, the issue isn't a matter of differing opinion on Tesla's appropriate cost of capital. The issue is the analysis under discussion starts with a false premise (retained earnings carry no attendant cost when reinvested into a business), and compounds the error by reaching conclusions (Tesla's discount rate = 0) that don't even have anything to do with the starting assumptions. The real irony of it is it appears Mr. Cox doesn't even realize that's what he's done.

Some of my opinion on Damodaran's model can be found here and here. I don't think they are particularly material, though. I certainly wouldn't take any action using them as a basis.

Thanks for your reply. Unfortunately, I'm still confused, probably because I'm not trained in finance. Let me try to rephrase my question in simple terms.

My understanding is Damodaran assumed an enormous amount of TSLA share dilution in the coming decade, due to an enormous amount of capital raising to fund Tesla's growth. Julian believes that no such dilution and capital raising will be necessary to achieve that growth, because Tesla can generate the necessary cash internally.

I don't know what terminology to apply to this difference in assumptions, or where to plug the different numbers into Damodaran's spreadsheet, but it seems to me that assuming a huge capital raise vs. no capital raise will make a huge difference in the model's result.

I don't have time or interest to understand the model in detail. But are you saying that Tesla will need to do another capital raise to fund its growth? If so, how much do you think they will need, and what current share valuation will result from plugging that assumption into the model?

 

[FluxCap]

Palpatine I agree with much of your premise, but it's important to distinguish between variable cash needed to fund operations (COGS) and non-variable/fixed CapEx. Night and day issues, and the former has a massive impact on discounted cashflows, the latter a much less significant one.

With a Cash Conversion Cycle of -15 days, Tesla literally books revenues with profits BEFORE booking costs because of their revenue and expense model. Operating cashflow required per product (vehicle) is essentially nonexistent at this point, and all that remains is CapEx, which I do agree requires cash, but as you say this should be ridiculously simple for a company with as enviable an income statement and cashflow profile as Tesla.

 

[PeterJA]

Having grown a company myself from nothing, I can say from experience, growing production capacity quickly with internally generated profits is tough. Even when profitable, it is typically not enough profits to double your production capacity on internal cash only.

Surely that depends on the amount of profits. Tesla projects gross margins greater than 25%, which I understand is much larger than other automakers have (except Porsche). So I'm not sure Ford and GM are appropriate examples for comparison.

 

[Palpatine]

Palpatine I agree with much of your premise, but it's important to distinguish between variable cash needed to fund operations (COGS) and non-variable/fixed CapEx. Night and day issues, and the former has a massive impact on discounted cashflows, the latter a much less significant one.

With a Cash Conversion Cycle of -15 days, Tesla literally books revenues with profits BEFORE booking costs because of their revenue and expense model. Operating cashflow required per product (vehicle) is essentially nonexistent at this point, and all that remains is CapEx, which I do agree requires cash, but as you say this should be ridiculously simple for a company with as enviable an income statement and cashflow profile as Tesla.

Under either scenario, to get that CCC, they need a healthy balance sheet (aka lots of cash) to get those terms from suppliers. Correct?

As to CAPEX, everything is proportional. We can project towards Gen III numbers a bit comparing with current Model S numbers. To handle 300,000 cars per year, they will need proportionally more production equipment, parts, employees, service center space, Superchargers, etc. Tesla Motors is a tech company and based on their history, their balance sheet with be safer than comparable auto companies. More equity, less debt. To me that would indicate more dilution coming to scale up.

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Surely that depends on the amount of profits. Tesla projects gross margins greater than 25%, which I understand is much larger than other automakers have (except Porsche). So I'm not sure Ford and GM are appropriate examples for comparison.

During the growth phase their margins per car might be 25%, but that doesn't mean it grows cash on the balance sheet. It just helps them stay closer to cash flow neutral to plow those gross profits into other areas of the business.

Large auto companies (Porsche, GM, Ford) also don't have the new startup expenses that Tesla will have in the next few years. Their distribution and support networks are already established. Tesla still needs to establish that network and scale it up.

If you listen to the last conference call, Tesla is not guiding anyone to believe their cash will grow. They specifically said they are aiming for cash flow neutral, but with their current CAPEX that will be tight. They might report earnings, but cash balance can still fall while being "profitable". Nobody should be surprised if cash balances decline as they gear up for Model X. $750 million in the bank as of the last report. I would expect they can get as low as $400 million before doing another market offering of either debt or equity.

That is not a bad thing. It is to be expected during a heavy growth phase with large CAPEX. I really think we are only talking about 7% to 10% dilution to get to Gen III.

 

[ModelS8794]

Thanks for your reply. Unfortunately, I'm still confused, probably because I'm not trained in finance. Let me try to rephrase my question in simple terms.

My understanding is Damodaran assumed an enormous amount of TSLA share dilution in the coming decade, due to an enormous amount of capital raising to fund Tesla's growth. Julian believes that no such dilution and capital raising will be necessary to achieve that growth, because Tesla can generate the necessary cash internally.

I don't know what terminology to apply to this difference in assumptions, or where to plug the different numbers into Damodaran's spreadsheet, but it seems to me that assuming a huge capital raise vs. no capital raise will make a huge difference in the model's result.

I don't have time or interest to understand the model in detail. But are you saying that Tesla will need to do another capital raise to fund its growth? If so, how much do you think they will need, and what current share valuation will result from plugging that assumption into the model?

Of you read through to the second link I gave, you can see some SWAGs at that question. I agree that Damodaran's low ROIC and high capital intensity are probably inappropriate. Further, I believe its the key debate to resolve, so kudos for asking the right questions. Whether or not Tesla ever needs to raise capital again is more a question of how quickly they want to grow, so tough to say. I believe their strategy as currently stated (30-40k S, initial X rollout, and on to Gen3) won't require another raise at least as far out as Gen3 launch (I have no clue beyond that, it'll depend on too many unknowns IMO). However I believe once they conclude a second S production line is a good idea, they will do another equity offering to pay for it, rather than use can on hand that is earmarked for Gen3 development.

None of this has the slightest to do with cost of capital though.

 

[PeterJA]

During the growth phase their margins per car might be 25%, but that doesn't mean it grows cash on the balance sheet.

We were talking about growing production capacity, not growing cash on the balance sheet.

If you listen to the last conference call, Tesla is not guiding anyone to believe their cash will grow. They specifically said they are aiming for cash flow neutral, but with their current CAPEX that will be tight. They might report earnings, but cash balance can still fall while being "profitable". Nobody should be surprised if cash balances decline as they gear up for Model X. $750 million in the bank as of the last report. I would expect they can get as low as $400 million before doing another market offering of either debt or equity.

Since Tesla said they are aiming for cash flow neutral, everyone should be surprised if their cash declines by $350M. Tesla also specifically said they will not need another market offering. For me, that outweighs your intuition based on your business and Ford and GM.

 

[FluxCap]

Whether or not Tesla ever needs to raise capital again is more a question of how quickly they want to grow, so tough to say. I believe their strategy as currently stated (30-40k S, initial X rollout, and on to Gen3) won't require another raise at least as far out as Gen3 launch (I have no clue beyond that, it'll depend on too many unknowns IMO). However I believe once they conclude a second S production line is a good idea, they will do another equity offering to pay for it, rather than use can on hand that is earmarked for Gen3 development.

None of this has the slightest to do with cost of capital though.

All of it has everything to do with the cost of capital as well as the need for capital. Either your modeling of TSLA's pro forma financials includes external financing (capital) at some point (and cost) in the future, or it does not. Julian's model is predicated on Elon's statement that they *will* fund all of their expansion with cashflow from normal operations. This is what is so staggeringly hard to believe for almost anyone trained in normal cost structures for manufacturing enterprises, myself included. Yet, I find myself believing it.

Either way, the shares price that "pop out" of most models (with or without pro forma financials) are heavily dependent on future costs of capital and assume varying degrees of external financing.

Yet a seemingly crazy statement like Elon has made regarding the lack of need for additional financing OF ANY KIND (debt or equity) necessitates an equally unprecedented modeling of future financials. This is precisely what Julian has done. You can certainly disagree with the premise that there will not be a need to raise capital, but be sure you are disagreeing with the right thing. Julian never said the COST of capital was zero, he said the NEED for capital was zero:

Thank you for the many kind comments. I trust my use of British English can be pardoned.

It looks like it is worth clarifying that I am not suggesting that external capital raised by Tesla would come at zero cost.

It's not the forward looking cost of capital that is zero if a fund raiser is required, the zero multiplier is the amount of external capital required = none, nada.

The thing that I have laboured to clarify is the fact that Tesla really does have a cash-flow-positive core business. Elon is not lying when states that he Tesla can and almost certainly get ready for production of 200,000 Gen III in 2017 on $1 Billion of internally generated cash.

From Julian's analysis:

Note in May 2013 Tesla raised $650 million by issuing bonds at the cost of capital of 1.5% (far below the range of 9.18% and 10.79% given). No new external funding is anticipated to be sought in 2014 and beyond.

Following this round of funding CEO Elon Musk went on record to state that:
* Sales of the Model S were cash flow positive.
* That readying Gen III for production in late 2016 (on an order of magnitude increased volume of production when compared with Models S and X) would cost the company approximately $1 Billion USD.
* That this $1bn. capital requirement would be met by internally generated cash, in other words from sales of the Model S and the Model X, not from dilution and not from borrowings.

To reiterate, when entering the correct figure according to guidance and with proper appreciation of the Tesla cash flow model for cost of capital in the period 2014~2018 (which is 0%, not 9.18% or 10.79%) Prof. Damodoran’s calculations yield a net-present valuation as at September 4th 2013 of $200.56. Not $67.12 as widely reported.

Also ModelS8794, you have conflated cost of retained earnings applicable to shareholder requirements with cost of capital for funding and financing a business, and as Julian pointed out, these are not even remotely the same thing.

 

[Palpatine]

We were talking about growing production capacity, not growing cash on the balance sheet.

To handle proportionally more vehicles, they also need proportionally more cash on the balance sheet to handle that scale of an overall enterprise enterprise.
It is not reasonable to think that Tesla can grow from $2 billion in annual sales (now) to $15 billion in annual sales (approx 300,000 cars per year) without also having larger amounts of cash on the balance sheet.

They also don't have the gross margins that Tesla expects to have (except for Porsche).

They also don't have the expansion expenses that Tesla needs to spend in the next few years to grow.

Since Tesla said they are aiming for cash flow neutral, everyone should be surprised if their cash declines by $350M. Tesla also specifically said they will not need another market offering. For me, that outweighs your intuition based on your business and Ford and GM.

Their cash won't decline by $350 million in one quarter. But as they scale out the Superchargers, stores, service centers, new production line for Model X, etc, all of those things will likely cause a decline in cash over the coming 4 quarters.
The Model S by itself is likely not profitable enough to fund 100% of the growth of Tesla Motors. I am sure it is contributing some amount to the bottom line, but not enough to offset all of those expenses.

Elon Musk also stated in early May that he didn't expect to do an offering. Then about two weeks later he did it.
That is what they always tell the public. Nobody tells the market they are going to be doing a secondary offering before they do it.
It is just announced and the pricing of it happens within 24-48 hours.

I have no position in TSLA. I am just an owner of the car with experience in growing my own business.
But anyone with common sense should be able to see that Tesla will need to raise more money in a few years to expand into that Gen III rate of production.