- Despite the closure of its main factory in Fremont, Calif., for nearly half of the second quarter, Tesla Inc. continued to improve profitability and cash flow generation. Moreover, we think the company's competitive position continues to strengthen with improved cost absorption on larger volumes, higher operational efficiency, and process automation.
- Consequently, we are raising our issuer credit rating on Tesla to 'B+' from 'B-'.
- We are also raising our issue-level ratings on its unsecured debt to 'B+' from 'B-'.
- The stable outlook reflects our view that Tesla's competitive position remains solid and its credit metrics will stay in line with our expectations.
NEW YORK (S&P Global Ratings) July 28, 2020—S&P Global Ratings today took the rating actions listed above.
Tesla's performance in Q2 shows improving profitability and cash flow generation, benefiting its competitive position. Despite U.S. light-vehicle sales being down about 35% year-over-year in Q2, Tesla's deliveries were down only 5%. Also, to offset the financial impact of suspended operations, the company took actions to reduce its costs, helping it reach a GAAP operating margin of 5.4% and $418 million in free operating cash flow.
Though recent improvements were partially driven by an increase in regulatory credit revenue (which accounted for nearly 30% of its automotive gross profit in the first half of 2020), we expect ongoing improvements in product and manufacturing costs, driven by Model Y and China-made Model 3, and improved aftermarket software and connectivity revenue. This should help the company sustain EBITDA margins over 10% over the next two years, which should support improved cash flow metrics.
Specifically, we see debt to EBITDA in the range of 3.5x to 4.0x in 2020 and moving below 3.5x in 2021. We also view the company's cash flow generation capacity as improving; this, and the $8.6 billion of cash on its balance sheet at the end of Q2, should support greater financial flexibility to fund the expansion of its manufacturing footprint and address its maturing convertible debt over the next 12 months.
The stable outlook reflects our view that Tesla's financial performance will stay in line with our expectations, namely debt to EBITDA below 4x and positive free operating cash flow (FOCF) generation, even as the company expands its manufacturing footprint around the world.
We could consider raising the ratings if the company continues to ramp up its production of the Model 3 and Y globally, with consistent operational improvements, such that EBITDA margins remain over 10%. We would also expect demand for Tesla's electric vehicles to grow, even as the number of EV models from competing automakers proliferate. Alternatively, we would look to financial metrics as confirming Tesla's strengthening market position, such as increasing gross margins and a debt to EBITDA ratio of below 3.0x on a sustained basis.
We could lower the rating if the company encountered problems expanding its manufacturing footprint, if demand for electric vehicles did not match the newly installed capacity, or competition from traditional automakers intensified and drew customers away from buying Tesla's vehicles. Also we could lower the ratings if the debt-to-EBITDA ratio exceeded 4.5x on a sustained basis.
We expect governance and social risk factors to remain high and have an increasing influence on Tesla's credit quality. Its environmental risks are minimal relative to other automakers, given its focus on fully electric vehicles and ambitions to expand aggressively into heavy-duty trucks and energy storage markets.
Governance risks will remain a bigger negative for credit quality than environmental and social risks, given the risk that CEO Elon Musk violates securities laws on fair disclosure and the recent high rate of senior executive turnover. We view the effectiveness of the committee that oversees Mr. Musk's communications as poor, given the rising risks from current and future litigation (as demonstrated by the 2018 subpoenas from the U.S. Securities Exchange Commission and related investigations from the U.S. Department of Justice). We view key-man risk as very high for Tesla, given Mr. Musk's dominant role in the company. In late 2018, the settlement with the SEC, under which Mr. Musk resigned as chairman of the board of directors but remained CEO, averted a significant disruption to Tesla's operations.
Social risks will intensify into the next decade as potential accidents, fires, and cybersecurity breaches could increase the risk of product liability, government scrutiny, and further regulation. Until those risks abate, in our view, Tesla's progress toward improving safety through the successful deployment of its autopilot technology will at best remain credit neutral for the foreseeable future.
From an environmental risk perspective, we think Tesla has an advantage over competitors given its battery and powertrain technology, the superior range per kilowatt hour (kWh, as rated by the U.S. Environmental Protection Agency) of its vehicles compared with upcoming launches, and ability to improve vehicle performance through over-the-air software updates.
Given its high reliance on batteries and other customized components, Tesla's limited and often single-source supply chain exposes it to multiple potential sources of delivery failure or component shortages. This happened in 2012 and 2016 in connection with production delays for the Model S and Model X.
