I interrupt the current BTC programming to share my thoughts after reading through the 10-K. I think there are some very interesting comments laced through the disclosures, as well as some subtle tweaks to language from prior years.
TL;DR:
- Market underappreciates the year over year Gross Margin improvement as well as how much operating leverage Tesla has achieved;
- Deferred Tax Asset Valuation Allowance saga continues, and will continue to snowball in size. Compounded with operating leverage, this is a significant future unlock of net operating margins;
- Stock based compensation is impacting multiple expenses categories (cost of goods sold, R&D, and general operating expenditures); this directly impacts a number of the standard ratios and metrics analysts use to value financial health and valuation of companies and makes Tesla very difficult to compare against "peers";
- Tesla intends to establish its own ride-hailing network - this is no longer just speculation or inference from a robo-taxi blue sky presentation from years ago - they explicitly state it for the first time in their 10-K;
- I am expecting announcements of at least two new factories in 2021;
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Gross Margins (GM): Margin expansion was actually stronger than it appeared. 2019 had a downward revision ($451M) to Cost of Goods Sold (COGS) due to management having increased the likelihood of resale guarantee utilization (remember that program where Tesla guaranteed a certain percentage of resale values?). If estimates are that more people will exercise that option, then Tesla buys back the vehicle and gets to resell it (assumed at a gain, as they would tack on full FSD on re-sale). Management had increased their estimate utilization of that program, so they decreased the COGS related to vehicles subject to those options so as to account for the potential future gain on resale. This made 2019 GM higher (and likely was what they needed to keep margins above the 20% threshold).
Moreover, Tesla had $213M of idle capacity charges (i.e., you still incur costs relating to your factory even if its not producing anything - those costs get charged to COGS - essentially increasing the overall COGS per unit produced from that factory in the year), relating to factory shut downs due to pandemic. So, if you add $451M to 2019 COGS and remove $213M from 2020 COGS, you actually get to a 2019 GM of 19.1% (vs. 21.2%) and a 2020 GM of 26.4% (vs. 25.6%). That's impressive GM growth and shows the power of localized manufacturing (e.g., Shanghai) and equally highlights the benefits of Model Y cost structure being similar to Model 3, yet priced at a premium. I would not be shocked to see Tesla pushing 30-40% GM in the near future, especially if FSD take rates improve at all.
For transparency, estimates around the resale options as well as warranty reserves are two HIGHLY subjective areas and would be one area that management can pull a lot of accounting levers to achieve desired outcomes. In fact, this is fully disclosed in PwC's audit report as critical areas of the audit. This essentially is a cover-your-*** statement from PwC should the actual resales value program utilization or actual warranty expenses vary materially from current management estimates.
Deferred Tax Asset (DTA) and Valuation Allowance (VA): Tesla has been accumulating tax losses and tax credits for many years. Generally, when an entity accumulates these losses and credits, they effectively are building DTAs, assets that they will be able to apply against taxes payable in future years due to future profitability. From a financial reporting perspective, entities can only show this as an asset on their balance sheet if there is a "more likely than not" (generally >50%) probability that they will actually consume the assets in the foreseeable future. Tesla has yet to agree with their auditors as to the likelihood of utilization of some of these DTAs. As such, they have applied a VA against their DTA. Fancy way of saying they are valuing the DTA as $0 for reporting purposes.
If and when they release that VA, it will be a $3B+ boost to Net Income and a significant lift to Operating Margin %s. I would estimate we see all or part of that VA be released over the next 1-3 years. The reason for the range (rather than my taking the stance that 2021 WILL be the year of release of VA) would be that Tesla currently generates significant tax deductions due to their stock-based compensation (SBC) plan with Elon, and to a lesser extent, most of their employees. As those shares/options vest, Tesla gets significant tax write-offs relative to their Financial Statement Net Income. As long as those write-offs are sufficient to off-set immediate taxes payable, Tesla may not release the VA on their accumulated DTAs. Though at current market cap and operational milestone pace, it's likely that the CEO compensation package is fully taken in to account within the next 1-2 years which, compounded with continued growing profitability, would culminate in a release of the VA in that 1-3 year window.
R&D Expense: Increased $148M year over year, $62M related to materials testing (could be prototype equipment, could be testing different raw materials for battery chemistry or manufacturing processes, either way - its a lot of something), and $61M due to SBC on R&D staff.
SG&A: More than 100% of growth in SG&A expenses was from... you guessed it... SBC. SG&A would have otherwise decreased, which again confirms the theory that Tesla is now at the point in their growth journey of unlocking MASSIVE operating leverage. In other words, Tesla's rate of generating sales far outpaces its rate of incurring operating expenses, meaning incremental vehicle sales will continue to disproportionately increase Net Income, and thus Net Operating Margin %, and thus EPS. I would not be surprised to see double digit Net Operating Margin in the next 2-3 years (from the current 2.2%) especially when you consider the potential release of VA on DTAs. This is a significant potential unlock to valuation of Tesla as analysts get comfortable with that reality.
FSD: This is the first time I've seen Tesla explicitly state that "We intend to establish in the future an autonomous Tesla ride-hailing network, which we expect would also allow us to access a new customer base even as modes of transportation evolve."; I checked their 2019 10-K and most recent 10-Q and there is no mention of that intention. This will add fuel to the revenue streams that analysts will be forced to consider in their own valuation models and again solidifying a significant portion of Tesla's valuation.
Engineering: Similar to FSD, Tesla has made a new statement in this 10-K "As we increase our capabilities, particularly in the areas of automation, die-making and line-building, we are also making strides in the simulations modeling these capabilities prior to construction." Making the machine that makes the machine. Tesla's product road map is as much factory design and building as it is the products those factories build. I would not be shocked to hear of several new factory announcements this year and equally not be shocked if we see the ramp in Berlin and Texas to be significantly faster than Shanghai.
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Conclusion: Anyone selling off because of BTC is forgetting that this is still just the beginning for Tesla.
