Debunking Tesla's "3,000 Unsold Cars"

Some analyst reports aren't worth any ink. That's how I initially felt about a note from research analyst John Lovallo at Merrill Lynch that made rounds under a doomsday headline at Daily Kanban that read, "Brokerage: Tesla could be sitting on 3,000 unsold cars." The market seemed to agree that the note was fluff, as the stock didn't budge. But as noise surrounding the note continues to crowd the interwebs, and after a recent piece I wrote that observed how Tesla Motors (TSLA -3.40%) thinks about demand was mistakenly considered by Daily Kanban's Bertel Schmitt as a counter to the note (though it didn't mention the note once), some ink on the silliness may now be worthwhile.

Model S in Hong Kong. Due to Tesla's expanding global presence, the company should end any given quarter with several thousands of vehicles in finished goods inventory, with the majority of vehicles in transit to abroad locations. Image source: Tesla Motors.

Extra inventory or not?
The analyst note from Merrill Lynch asserted, among other things, that Tesla's finished goods inventory of approximately 3,000 vehicles is a problem. The premise was that the finished goods inventory in Tesla's 10Q told a different story than CEO Elon Musk's claim that "there was just nothing left to sell" in Q3.

"Tesla's finished goods inventory at the end of 3Q appears to tell a different story," Lovallo argued. By his math, the finished goods inventory of $226 million was the equivalent of about 3,000 vehicles.

So, was Musk really fibbing?

Before we dig in, it's worth noting that Forbes contributor Mark Rogowsky already did an excellent job at exposing the flaws in the rationale behind Lovallo's arguments. In his objective, fact-based, and original analysis, Rogowsky dug into the financial statements to find out what was really going on. Even Schmitt, after putting Lovallo's report on a pedestal, had to stoop low to have anything negative to say about Rogowsky's take-down. Schmitt's only clear counter to the piece was that "just about anyone can publish" an article at Forbes.

Following Rogowsky's attempt to debunk unnecessary worries about inventory, here's one more attempt to clear the air. I'll keep it as simple as possible.

A visit to the 10Qs
It's amazing how much information is contained in company SEC filings. It's also amazing how little of this information is in the press. Let's use them to our advantage today.

First and foremost, Tesla's Q3 10Q mostly solves the concern about inventory in one line: "Finished goods primarily include Model S vehicles that were in-transit to our foreign locations for customer delivery."

Furthermore, once you zoom out a bit, 3,000 vehicles' worth of finished inventory headed into Q4 actually seems like a very small number. Given Tesla's guidance to sell around 11,200 vehicles in Q4, the company will need to produce and deliver around 8,200 vehicles in Q4 alone to hit its target if it only had 3,000 vehicles in finished inventory. And then, of course, the company will likely attempt to end the quarter again with 2,000-3,000 vehicles in transit to waiting customers in foreign locations; so, with only 3,000 vehicles of finished inventory headed into Q4, Tesla will likely need to produce around 10,200-11,200 vehicles -- far higher than the 7,000 vehicles the company produced in Q3 and still meaningfully higher than the 9,000 it had planned to produce in Q3 before the company ran into production hiccups.

Tesla's vehicles are produced in the U.S. and a growing percentage of cars are exported abroad. Image source: Tesla Motors.

Then, once you consider that the company expects sales outside North America to reach almost half of all global auto sales by the end of 2014, 3,000 vehicles in transit to abroad locations starts to look even smaller. Indeed, as Rogowsky pointed out, some simple math using the data provided in Tesla's 10Q reveals that China sales accounted for around a quarter of the company's Q3 deliveries -- a surprisingly high number considering Tesla just entered the market in April. The high percentage of revenue coming from China makes the case that Tesla likely needs a significant number of vehicles in transit abroad to meet demand in its growing China market. Of course, Tesla will also need to serve Europe, Japan, and maybe even Australia in Q4.

In other words, shareholders had better hope Tesla really has 3,000 vehicles in finished goods inventory heading into Q4. If anything, a finished goods inventory of just 3,000 vehicles shows just how lean Tesla is running its business. Only 3,000 vehicles in finished inventory with the majority of them in transit to foreign locations means Tesla doesn't have any room for production blips in Q4. In fact, for Tesla to meet its Q4 guidance, it will need to meaningfully ramp up its production from last quarter.

Finally, Lovallo's sudden concern about inventory is particularly interesting since the company's finished goods inventory is actually down 10% sequentially in Q3, despite the fact that Tesla is guiding for about 44% higher deliveries in Q4.

So, back to our question: Was Musk fibbing when he said the company sold every car it could? It doesn't look like it. In fact, 3,000 vehicles, most of which are in transit abroad, looks like a small number for entering a quarter in which Tesla plans to sell about 11,200 vehicles -- of which around 40% may be delivered abroad.