Tesla (NASDAQ:TSLA) is a polarizing company. It's often among the most shorted stocks on the market, in large part because of quarterly reports like the one it just delivered.

In this week's episode of Industry Focus: Energy, host Sarah Priestley and Motley Fool contributor Daniel Sparks dig through Tesla's report and explain the bright spots, the areas to watch out for, and where Tesla might be overselling itself. Click play to find out how production is going for the Model X, S, and 3, and how the company sees things changing; how competition from major automakers such as Chevrolet is probably helping Tesla more than it's hurting; what Elon Musk's new compensation plan might and might not mean for the company; and more.

A full transcript follows the video.

This video was recorded on Feb. 22, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It is Thursday, the 22nd of February. And today, better late than never, we will be discussing Tesla earnings. I'm your host, Sarah Priestley, and joining me on Skype all the way from Colorado, which I'm assuming is sunny, is Motley Fool contributor and senior technology specialist, Daniel Sparks. Daniel, how are you doing?

Daniel Sparks: Good. Thank you, Sarah!

Priestley: Is Colorado sunny? Or have I actually just projected that?

Sparks: No, it's actually not sunny.

Priestley: [laughs] That makes me feel a little better.

Sparks: Yeah, it's been really foggy lately.

Priestley: It's pretty rainy here in Washington. Yesterday, I think we almost got up to the 80s, so I shouldn't complain. In February.

Sparks: Man, that's a lot better than here. It's been 40 and below for the highs every day.

Priestley: Ooh. Well, Tesla seems a bit like a stock that some analysts are loving to hate at the minute. It's also the most shorted stock on the market the last time I checked. Fourth quarter results saw the company announce its worst quarterly loss ever, and also record revenue. Just to give listeners a rundown, vehicle deliveries were up 34% for the quarter year over year. Revenue, $3.29 billion, up 44%. Non-GAAP earnings per share, a loss of $2.35. GAAP earnings per share, a loss of $4.01. A pretty interesting quarter. It's not often that you see a company announce its worst quarterly loss and also record revenue. Per-unit vehicle production costs were negatively impacted by the company's gross profit margin. Daniel, what did you make of the results?

Sparks: This is really a typical Tesla fashion here, when you have record revenue and widest-ever loss. Of course, the results were better than expected, even that wider than expected loss, on an adjusted basis. But it's still a trend that investors are taking notice of, just because, the loss comes in narrower than expected. Investors should look at these numbers and maybe take some time to look at the financial statements, because these are enormous losses. And we'll getting into the huge negative free cash flow Tesla reported in 2017 in a bit. But if Tesla continues down this road, it would be very concerning. Of course, they are laying the groundwork for significantly higher deliveries this year. Tesla does expect sales and gross profit to jump this year. If that does happen, of course, in retrospect, these could look like well-time investments, a year of very smart investment. But if it doesn't pan out as expected and delays persist, that could be an issue. That's kind of how I'm looking at the quarter.

Priestley: Absolutely. I think 2017 was an interesting year for them. You saw rapid sales growth. They obviously introduced the Tesla semi and the Roadster, but we've seen this huge jump in spending. And quarterly deliveries hit a record high. The constant commentary that you've seen around Tesla is its production misses. Which, it continued to miss production targets, but it's hit a record high quarterly delivery of 30,000 units, that was up about 30%. But this was driven by the Model S and X. What about the Model 3?

Sparks: The Model 3, the thing to look at here is, like you said, they've been missing production targets. The last time they announced they were pushing a production target for the Model 3 back was alongside their fourth quarter delivery announcement, which happened about three days into 2018. So investors, of course, were looking to see if Tesla would push it back again, which would be a third time. For some context, they were initially expecting to ramp up Model 3 production to 5,000 units per week by the end of last year, and they royally missed that target, and initially pushed that target back to the end of the first quarter. Then, earlier this year when they announced deliveries, they pushed that target back to the end of the second quarter. 

And Tesla did actually maintain that target when they announced earnings, even though they took place over a month into Tesla's first quarter. So, that was encouraging, to see that they're still aiming for a weekly production target of Model 3 of 2,500 units by the end of this quarter, which of course is just over a month away now, then 5,000 units per week by the end of Q2. They did maintain that. That was probably the one good news about Model 3 we've seen so far. Of course, just because they maintained it, with these delays in hindsight, it's still something investors should watch closely. We really can't take Tesla at their word yet.

Priestley: [laughs] Absolutely, yeah, if there's one thing that we've learnt so far. Just to recap for anybody listening that's not familiar, Tesla announced the Model 3, I think it was almost two years ago, it's the company's affordable mass-market electric vehicle, and I think the base model costs $35,000. It's supposedly gotten around 500,000 reservations during the first year that they announced it. So, potentially hugely successful, but as you talked about, Daniel, it's really if they can crack that production. 2,500 Model 3s every week by the end of this quarter is going to be a huge ramp up for them. I've seen some estimates that have pegged average production at the end of last month at 1,050 per week. You don't know. It's hard to gauge. You don't know necessarily where these analysts are getting those figures from, but it'll be interesting to see if they actually manage it.

What about the Model X and Model S? I think there's difficulties on that side, too, with some bottlenecks and issues there. What's demand looking like for these vehicles?

Sparks: With the Model X and S, they did finish the year slightly above where they anticipated. That's one target they exceeded last year, just over 100,000 deliveries of just the Model S and X combined. That was encouraging. Of course, they had already announced deliveries for the quarter, so it wasn't really deliveries we were looking at, but, yes, demand and what to expect in 2018.

The bottlenecks you mentioned for Model S and X are kind of a chosen bottleneck at this point. What Tesla wants to do is keep a steady state of production around the 100,000 annual unit rate that they're at right now. They are working with their partner Panasonic for the battery form factor on those. So, the form factor they're using is not the one that they brought to the Gigafactory for Model 3. So, what they've done is, instead of ordering incremental capacity from Panasonic, which would be quite a significant investment, they're hoping that demand for the Model S and X will continue to increase in 2018, and they could really focus on highly optioned vehicles and get that gross margin up on Model X and S from a steady state of around 25% for those two vehicles, to push it higher around 30%. 

That's where they're at right now. And actually, they've already sold out of about half of the Model X and S units for the year. So far, it's actually working out the way they wanted, and it's actually been kind of surprising, the Model 3 has been driving a lot of interest to the Model S and X. And of course, that could be partly because of the delays. But they're also putting the Model 3 in stores, and they're seeing a lot of positive traction from that. So, if you put in an order for a Model S and X now, you're actually waiting until June. It's getting closer to the Model 3 at that point. So, that's been a really interesting thing. Now we just need to see Tesla follow through on prioritizing the highly optioned vehicles, work on those gross margins.

Priestley: Yeah. As you said, the Model 3, once you've bought up all of your options to increase the value of it, you're probably looking at getting higher toward there Model S price anyway, I'd imagine. I don't know, necessarily, the upsell there. It'll be interesting to see. I think they're capping the supply of Model S and Model X to 100,000 units in 2018. Is that right?

Sparks: Yeah. They said around 100,000 units. So, what to expect in 2018 is, yes, around 100,000 units, but they do want to push the average selling price on those two vehicles higher. They've done that in the past. And the way they've usually done that is by eliminating features on the base model, including higher-end options on the base model, and simultaneously increasing that price. They could do that, or they could also introduce new features at the high end, they could further prioritize the highly optioned vehicles to give them much faster delivery than the lower-optioned Model X and S. So that's what we'll be looking for, is to really see that average selling price go up this year.

Priestley: And it's really good to see them focus on that, too.

Sparks: It is. It's actually very encouraging. Of course, an extra 5% of gross margin from those two vehicles can contribute significantly to both gross profit and operating income, so that'll be good.

Priestley: So we're going to get some more detail around cash and capital expenditure. Daniel, Tesla yet to turn a profit, but funding Musk's ambitious growth plans means the company is spending a lot of money. What's the cash burn looking like for 2017, and what are we expecting in 2018?

Sparks: They did guide for higher capital expenditures in 2018. 2017, capital expenditures were $3.4 billion. And they said for 2018, they expect that to be slightly higher. So just for some context, looking back in 2016, capital expenditures were $1.4 billion. In 2015, they were $2.2 billion. So, it's a significant jump from 2016's capital expenditure levels of $1.4 billion, the $3.5 billion-plus they're expecting this year. But you look back to 2015, which was actually much higher, at $2.2 billion, for the type of capacity expansion Tesla is planning for, $3.5 billion in this really capital-intensive business is not too bad and could be considered conservative. Of course, that could be considered smaller than maybe someone would expect for the capacity increase that they're planning for. 

Just for some context, they do ultimately want to get to that 5,000-unit-per-week target and eventually double that to 10,000 units per week for Model 3, and run that vehicle at about 500,000 units per year. Then, of course, last year, they produced just over 100,000. They're planning a huge incremental investment. But this doesn't mean investors should ignore the fact that even though it might be a small amount relative to the capacity they're aiming for, it isn't necessarily cash they have. They have huge negative free cash flow because of this. In 2017, the negative free cash flow was $3.5 billion. We really want to see this revenue from Model 3 and the Model 3 gross margin start kicking into high gear to cover those costs.

Priestley: Absolutely. As you said, without earnings, the company is completely relying on capital markets to essentially keep them afloat at this point. It was announced at the end of last year that in order to finance the Model 3 production ramp up -- which, I agree with what you said completely, that you could see that as conservative, given the ambitious growth targets that they have there -- the company is seeking to raise over $500 million, offering debt backed by Model X and Model S leases. They had absolutely no issue selling these. They were 14X oversubscribed. I think this was mostly thanks to the fact that they were offering yields about 3% higher than standard lower-rated portions of debt. So, there was a ton of commentary in the financial media about this. People were misinterpreting and reinterpreting it all over the place. But what did you make of it? Is this a cause for concern, do you think?

Sparks: Any debt is a cause for concern when you have the negative free cash flow that Tesla does. Really, it reinforces the position that investors are in right now, where they're really waiting for Tesla to actually deliver on this much higher revenue, and a pretty heady gross margin target for the Model 3 of 25% by the time they get around to 5,000 units per week. So yes, I would say any debt right now is a concern, until Tesla can actually start showing us they can do what they want. 

But as far as the structure of the debt itself, this goes along with how Tesla has been shifting away from selling equity to issuing debt. So, clearly, they do believe in their business, because they're trying to dilute stock less. It was similar to their last issuance of debt before this, where they more heavily weighted the debt side of it instead of the equity, which was really interesting. But, this creates a lot of risk for investors, because selling equity gives you cash without the debt, but it does give you the shareholder dilution. So now, investors have these interest rates. And like you said, one of the reasons they got so much attention was because of the high rates on this asset-backed line. 

Priestley: And to be clear, the automotive industry is no stranger to debt at all. I think Tesla has about $10.3 billion total long-term debt on its books. Then, if you look at Ford, 75% of their capital structure is long-term debt, 60% for General Motors, and carrying a much higher proportion. But they're also in the green, so it's a different scenario for more mature automotive companies. It's definitely worth watching. It's interesting. But as you said, it's a toss-up between whether you would want your shares diluted or you would want them to be carrying this.

Sparks: Right.

Priestley: Something that I'm seeing more and more in bear cases is the rise of viable competition. For a while, at least, Tesla was kind of able to operate as somewhat of a monopoly -- I don't know if that's fair to say, but, producing, at least by reputation, the best electric vehicles. But that's really beginning to change. I think GM's Chevy Bolt, most analysts are pointing to this as a real competitor for the Model 3. Last year, I think GM sold 23,000 Bolts. And they're ramping up production in 2018. Some believe this is the real crux of the issue -- the production delays for the Model 3 are turning that demand toward the Bolt. The delivery day has been pushed out to 2019, and then the federal tax credit, which is going to be phased out in stages during that year, is also playing into people's consideration for that. What do you make of that? Do you think that actually has legs?

Sparks: I think all of those arguments, they do sound good in theory. But when we look at the facts of what's happening to Tesla's demand, the net reservations for Model 3 have never declined. There was a miscommunication, there was a misinterpretation of net reservations a while back, where they reported the reservations instead of the net reservations, so then they had to back it out and say, "No, this was actually what we meant, was the net reservations." But they've been steadily trending upward. 

What's really impressive is, in Tesla's fourth quarter report, they said that even during those two delays, that Model 3 net reservations remained steady. Which is pretty astounding, because those were significant delays. Like I said, they were expecting 5,000 units per week of Model 3 at the end of last year. And now, they're essentially six months behind. And the net total amount of customers has remained the same during that period. And they also said, in the few weeks leading up to the report, that net reservations resumed their upward trend. So, that's what's happening with demand for Tesla vehicles amid all this rising competition. Then, you look at the Model S and X, where you have a growing backlog of orders, even though production is remaining steady. 

The demand isn't being negatively impacted yet. It's something we should keep our eye on. But at this point, the potential addressable market is so huge that Tesla arguably needs help promoting just the idea of an electric vehicle. And when you have companies like General Motors coming in and offering a compelling Chevrolet Bolt, they might attract a type of customer that wasn't considering electric vehicles in the first place, or at least help make that case. Then, it gets new customers into the market for electric vehicles. And once they're into the market for electric vehicles, Tesla could be considered an option for some. Not all of them. But it represents such a sliver of the market, electric vehicles do right now, that Tesla actually needs help promoting the idea of, what is an electric vehicle, are they actually feasible, are they actually compelling. 

So I would say that's maybe the bull case to look at it. Ultimately, I think the takeaway is, it's not necessarily a win-lose market here, at least not yet, until we see signs of that.

Priestley: Absolutely. Anybody that was able to see me while I was listening to that could see me nodding away in agreement, because I completely agree with you. I think it's not a zero-sum game. Musk's whole intention with what he wanted to do was raise the profile of electric and get traditional automakers to take advantage of it and essentially raise the profile, as you said. So, in my mind, I think this is a rising tide lifts all boats, and there's plenty of demand to go around. It's obviously not just competition from the Bolt on the lower end, but the higher end of the product line is beginning to be challenged. There's more options, is another way to look at that. Tata Motors' Jaguar I-Pace is going to be shown at the Geneva Motor Show. It's a cheaper alternative to the Tesla Model X. I would not consider myself to be a Tesla bull, I have some issues and concerns with the company, but this actually is not one of them. I think you're exactly right. It's a small part of the market right now, but there's plenty of that small slice of pie to go around, and I think it's only going to get bigger.

Sparks: Right. And I would say, what could make it a zero-sum game would not be competition from fully electric vehicles, but it would be if another vehicle type, particularly maybe a green vehicle type -- there was all this talk about hydrogen fuel cells, and the hype around that has died off a little bit -- but, if there were a new vehicle type that threatened the idea of fully electric vehicles, at that point, we could worry about a potentially zero-sum game. But as long as fully electric vehicles are catching on in the mainstream market, I think, like you said, it's a tide that lifts all boats.

Priestley: And, sorry, not to hammer this issue too much, but if everybody is on electric, there's going to be more investment in electric infrastructure, it's going to become increasingly viable. So, I definitely agree with you there. 

The last thing I wanted to really get your opinion on is Elon Musk's new compensation plan that was recently announced. It caused, again, a media frenzy, as anything announced around Elon Musk does. The plan could be worth $55 billion to Musk personally if he delivers on some astronomically ambitious goals. This is a 10-year plan that will mean he will only get paid if he achieves operational financial targets. He will only get paid if he achieves 80% or whatever, it's 100% of these goals, one of which is to raise Tesla's market valuation to $650 billion, which would make it one of the five largest companies in the U.S. today. For reference, Amazon's current market cap is about $640 billion. What did you make of this?

Sparks: It definitely screams Elon Musk and Tesla, and the way they've set about ambitious targets in the past. Of course, more recently, we've seen a lot of those targets being missed. I think that's why, when the compensation plan was announced, the market really didn't know what to do with it. It's almost like it was shrugged off as, whatever, we'll see what happens. 

But, when you look at the plan itself, there's a lot of interesting things. For instance, I think I remember in business school, I'm probably going to butcher this, but beyond a certain salary of some sort, they say it doesn't motivate people to achieve any targets. And like you said, a compensation plan that could be worth around $55 billion, I'm not sure if those sums are even necessary to motivate someone who's already a billionaire. But, maybe they are. 

The good news is, at least they're attached to astronomical market cap targets. And of course, the good news for investors is also that they tied them with some operational EBITDA targets. Which, for reference, the final target for EBITDA was around $14.5 billion annually, which is about 21X higher than where Tesla is at right now. They also would have to achieve these market cap targets. 

It's really interesting that it's tied to these big targets, but like I said, it's not very believable at this point, and that might be the issue with investors. So, hopefully Tesla can gain some traction this year, and we can come back to this compensation plan after they've started gaining this momentum, and see how realistic it really might be. But for now, it's just hard to believe.

Priestley: I agree with you. Going forward this year, I think we're going to be looking for, as you touched on, Daniel, the margin expansion that we're hoping they'll deliver. Revenue growth is expecting to exceed its 55% target. I think 2018 as far as Musk is concerned is specifically to demonstrate profitability and affordability of electric vehicles. And, they're aiming for that 25% gross margin at the end of the year for Model 3. If they can deliver that, I will be astounded, but very happy for shareholders.

Sparks: Yeah. [laughs] 

Priestley: Anything else you want to add before we go today?

Sparks: I think that's it. I think that covers it. Investors should really just keep an eye on that free cash flow, and hopefully it starts turning upward.

Priestley: Awesome. Thank you so much, Daniel, for being on the show today. As always, you are incredibly knowledgeable on the issue of Tesla, and I'm sure we'll get you back soon.

Sparks: Thank you, Sarah! Thank you for having me!

Priestley: That's it from us today. If you would like to get in touch, please feel free to email us at industryfocus@fool.com or tweet us on Twitter @MFIndustryFocus. Thank you to Austin Morgan for producing the show. As always, people on the program may own companies discussed, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Daniel, I'm Sarah Priestley. Thanks for listening, and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Daniel Sparks owns shares of Tesla. Sarah Priestley has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Amazon, Ford, and Tesla. The Motley Fool has a disclosure policy.