The good news for Tesla (NASDAQ:TSLA) investors in the company's Q2 earnings report was that the electric-vehicle pioneer didn't lose as much money last quarter as it did during the first three months of 2019. The bad news was that it still lost plenty of money, far more than analysts had anticipated.
In addition, CEO Elon Musk sowed further confusion about Tesla's future profit trajectory. The company also reiterated its full-year deliveries forecast, without providing much evidence that its target is really achievable. Finally, Musk offered a rosy -- but potentially unrealistic -- outlook for 2020 and beyond. All in all, the earnings report raised more questions than it answered. This caused Tesla stock to plunge 14% on Thursday, retracing its gains of the past few weeks.
Another hefty loss
In the first quarter, Tesla recorded a massive loss of $702 million, or $4.10 per share. In the second quarter, that improved to a loss of $408 million ($2.31 per share). Management noted that the company incurred $117 million of restructuring and other charges last quarter. But even adjusting for those expenses, Tesla missed analysts' expectations for profitability.
Tesla blamed its big quarterly loss on several factors. While deliveries reached a record of 95,356 -- slightly higher than the company's preliminary estimate -- Tesla began delivering the low-margin, entry-level Model 3 (priced at just $35,000) last quarter. It also cut the prices of older versions of its Model S and Model X, and regulatory credit revenue fell sequentially. As a result, automotive gross margin fell to 18.9% from 20.2% a quarter earlier and 20.6% in Q2 2018.
Excluding regulatory credits, automotive gross margin improved by about 2 percentage points compared to the first quarter. However, on that basis, automotive gross margin declined by more than 2 percentage points year over year.
In other words, despite cost reductions, it's clear that Tesla's price cuts -- of which there was another just this month -- and unfavorable mix shifts are hurting profitability in a big way. What isn't clear is whether Tesla may be able to stem the bleeding over time by continuing to reduce its costs and improve productivity.
Cash flow improves, but is it sustainable?
While Tesla lost a ton of money last quarter, it did generate $614 million of free cash flow. That was a nice turnaround from the first quarter, when it burned through more than $900 million.
The return to positive cash flow wasn't very surprising. Tesla produced 87,048 vehicles in the second quarter, whereas it delivered 95,356. Assuming an average selling price between $50,000 and $60,000, Tesla's sales of vehicles that had already been built may have added as much as $500 million to its cash flow last quarter. This was pretty much a one-time boost, as Tesla exited the quarter with very lean vehicle inventory.
Furthermore, capital expenditures totaled just $250 million last quarter. While Tesla reduced its full-year capex guidance this week, it would still need to spend an average of nearly $500 million a quarter in the second half of 2019 just to hit the low end of its new guidance range.
Normalizing for its inventory reductions and a more sustainable level of capex, Tesla's free cash flow would likely have been negative again last quarter. It remains to be seen whether the company can improve its underlying cash generation to keep free cash flow strongly positive over the next several quarters.
More orders and deliveries needed to hit 2019 targets
In conjunction with the earnings report, Tesla maintained its forecast that it will deliver between 360,000 and 400,000 vehicles in 2019. It delivered just 158,375 vehicles in the first half of the year, though. Thus, quarterly deliveries would need to average more than 100,000 over the next two quarters just to reach the low end of the guidance range.
On its face, that seems achievable. After all, Tesla delivered more than 95,000 vehicles in the second quarter, so its delivery pace wouldn't have to accelerate all that much.
However, demand and supply both represent potential hurdles that could hamper Tesla's ability to reach its goal for deliveries. On the supply side, Tesla produced just over 87,000 vehicles last quarter, so it would need to substantially raise output to reach its target. That might be feasible, but management has repeatedly overestimated Tesla's ability to implement sustained production increases over the past few years.
As for demand, Tesla's Q2 order activity may have been boosted by a looming cut to the federal tax credit for U.S. buyers. So far, there hasn't been a sharp drop-off in orders this quarter, but the recent price cuts do cast doubt on the strength of demand.
Two things that could change Tesla's trajectory
On Tesla's earnings call last week, Musk postulated that demand for the company's vehicles could surpass 2 million units annually within a few years. Tesla stock's post-earnings plunge makes it clear that most investors see this as wishful thinking. Indeed, just reaching the low end of this year's forecast by delivering 360,000 vehicles seems like it could be a stretch.
Yet this notional target isn't as outrageous as it may seem. Tesla is on track to start building the Model 3 in China later this year. That will allow it to avoid hefty import tariffs, enabling lower prices that could drive a surge in orders. Meanwhile, production of the Model Y crossover could begin as early as next year. Given that most consumers prefer crossovers to sedans these days, it's plausible that the Model Y will outsell the Model 3 by a wide margin.
On the other hand, Tesla will face dramatically more competition a couple of years from now than it does today. The Chinese auto market has been in free fall for the past year, so counting on China to drive a substantial amount of growth seems like a dubious proposition. And under current law, the Model Y won't benefit from any federal tax credits in the U.S., which could put its price tag out of reach for most consumers.
The disappointing second-quarter earnings report wasn't a sign that Tesla is doomed. That said, it raised a lot of uncomfortable questions about whether the company can achieve its lofty goals. Investors are still waiting for answers.