The big question for electric-car company Tesla (TSLA +2.08%) right now is whether it can become profitable in the second half of 2018. Losses have been mounting, and the company's negative free cash flow has been worsening.
Last year, Tesla's total net loss was $2.2 billion. Even worse, its operating cash flow less capital expenditures -- or free cash flow -- was negative $3.5 billion. Kicking off 2018, Tesla's net loss was $785 million in its first quarter alone and its free cash flow during the period was negative $1.05 billion.
Fortunately, Tesla CEO Elon Musk has said he expects the company to be both GAAP profitable and cash flow positive in both Q3 and Q4. Soaring Model 3 production and deliveries, Tesla asserts, will scale the company's production and help it achieve profitability. But is Tesla's outlook realistic?
Model 3. Image source: Tesla.
The strategy
To go from losing nearly $800 million in Q1 to being profitable by Q3 and Q4, Tesla's business will need some major growth. More specifically, management has said it needs to get to the point where it can sustainably produce 5,000 Model 3 vehicles per week to achieve this.
Ramping up Model 3 production from a rate of about 1,000 units per week at the beginning of the year to 5,000 units per week by the end of June has required significant investment. It stands to reason, therefore, that fixed costs per Model 3 unit produced would weigh heavily on profitability until Tesla ramped up Model 3 production to levels in line with what the company's Model 3 production line was built for.
On a more granular level, Tesla said in its first-quarter shareholder letter that its fast-rising Model 3 production would help the company go from a gross margin for the vehicle that is "slightly negative in Q1 2018 to close to breakeven in Q2 and then to highly positive in Q3 and Q4."
To make the numbers as favorable as possible in the second half of the year, the company is highly focused on selling only higher-priced versions of the Model 3. The long-awaited $35,000 Model 3 will have to wait until late this year or early next year.
To ensure demand for its premium versions of Model 3 is high enough to support Tesla's recently achieved production rate of 5,000 units per week, the company is deploying performance versions of its Model 3 vehicles to all U.S. stores and showrooms for test drives. Further, Tesla recently opened up the Model 3 online design studio to North America, letting anyone in the U.S. and Canada place an order for its long-range Model 3 versions. In addition, Tesla started featuring Model 3 at the top of its homepage on its website this week.
When you combine Tesla's shift from anti-selling the Model 3 with the company's use of aggressive marketing tactics with its approximately 420,000 deposit-backed reservations for Model 3 at the end of its second quarter, demand for Tesla's high-end Model 3 versions likely will be robust -- and possibly high enough to represent the bulk of Model 3 deliveries in 2018.
Some quick math
But do the numbers work? Assuming Tesla can deliver about an average of 5,000 Model 3 vehicles per week in the second half of the year and that Model 3 can sell for an average price of about $55,000 (currently available Model 3 versions are priced between $49,000 and $77,000), the Model 3 could help Tesla generate about $7.2 billion in revenue on top of sales from other vehicles and business segments during the second half of the year.
While it's unclear what gross profit margin Tesla believes it can achieve in the second half of the year for Model 3, management has said it wants to eventually achieve a gross profit margin of 25% for the vehicle. Therefore, assuming Tesla can make some progress toward this target, achieving a Model 3 gross profit margin of 15% would translate to about $1.1 billion in gross profit from the new vehicle during this time frame. And if the rest of Tesla's business can generate gross profit levels in line with what the company achieved in the second half of 2017, Tesla may generate about $2 billion in gross profit during the second half of the year.
Since Tesla's operating expenses recently have trended around $1 billion a quarter, Tesla may need to cut back its operating expenses to ensure it achieves profitability with $2 billion of gross profit in the second half of the year. Of course, Tesla is doing exactly that.
A Tesla Powerwall. Image source: Tesla.
Profitability in Q3 and Q4, therefore, is possible. But this is based on an overly simplistic forecast using what many may view as aggressive assumptions. On the other hand, it's always possible that this exercise underestimates the contribution from Tesla Energy or proves to be too conservative with regards to certain assumptions made about the company's Model 3 program.
For instance, this imagined scenario may undershoot the Model 3 average selling price or the number of Model 3 vehicles Tesla can deliver in 2018. After all, Tesla recently said it believes it can achieve a production rate for Model 3 of about 6,000 vehicles per week in late August. Further, Tesla's energy business is seeing significant momentum -- a trend management believes will persist in 2018. Rising sales from this segment could have a materially positive impact on total gross profit.
The point of this exercise is not to make a reasonable forecast for Tesla's profitability in the second half of the year, but rather to highlight how uncertainty about whether the automaker can swing to a profit still looms -- even if Tesla has significantly ramped up Model 3 production recently.
