To Tesla or Not to Tesla?

What's your opinion about Tesla (TSLA -1.11%)? Odds are pretty good it's a strong one. In this week's episode of Industry Focus: Energy, host Nick Sciple and The Motley Fool's analyst Brian Feroldi, respective bear and bull, discuss the state of the company today and explain why the same news can garner such wildly different reactions. Tune in to hear both sides on some recent updates, such as co-founder JB Straubel's departure, and the executive turnover issue in general; Model 3 sales numbers versus revenue; declining interest in the Model X and S; competition from the likes of Google and Baidu; upcoming debt payments, technology that may or may not be world-changing; the contractually and geopolitically fraught China Gigafactory; and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on Aug. 8, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Aug. 8, and we're discussing everyone's favorite company, Tesla. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Brian Feroldi via Skype. How's it going, Brian?

Brian Feroldi: Hey, Nick! I'm sure that listeners are very confused on what the healthcare and technology guy is doing on the industrials show, but I am happy to be here!

Sciple: Tesla is a fun company. Very divisive. But I haven't had you on the show in a while. Last time we had you on, we talked about solar companies. That also touches Tesla a little bit. How's your summer been? What have you been up to?

Feroldi: My summer is going fantastic, living the dream here. The big news for the Feroldi household is that my youngest kid, who's in day care, is going to be leaving in two weeks to go to kindergarten. The Feroldi household will be day care bill free for the first time in nine years. We are very excited. How's it going for you? 

Sciple: Going pretty good! You're putting the kids out of day care, I'm doing the childless millennial thing. Headed to Disney World with my girlfriend last week. Also did Universal. It's a great time! It's one of those vacations where you spend more time walking than you do when you're actually not on vacation. A little bit of that. It was a good time. But it's good to be back in the office!

We're talking about Tesla today. We're going to have you on, Brian -- this company has got to be the most divisive company in the stock market. You've got hyper bulls, hyper bears. I'm personally short this company via put options. You're long this company. How did you first come across Tesla, and what's your background with this company as an investment?

Feroldi: This is definitely the most divisive company I've probably ever seen in my years as an investors. The funny thing is, I know some people that I deeply respect their opinion are very short this stock. It is so funny how we can view the same information and come away with different views. But, hey, that's what makes it motley, and that's what makes a market. 

I will tell you, I am first came across this company as an investment when David Gardner recommended it for Rule Breakers many years ago. To be quite honest, when he did that, I actually made fun of him the next time I saw him to his face for picking it. I thought he was nuts for picking a car company, which have had long histories of being terrible investments and destroying value. But as I gradually got to know more about the company, gradually learned more about Musk and the opportunity, I switched and became a bull. I first became a shareholder in 2012. Despite all the rockiness over the last couple of years, I'm up significantly on my early purchases. How about you?

Sciple: I definitely came to this story a little bit differently. I never looked at this company as an investment until maybe a couple of years ago. One of my closest friends is an EV engineer at a major OEM in the U.S., and he started talking to me about Tesla. I'd seen Teslas, you go to the mall and they're parked out there for you to look at. It's a really cool car. He started telling me some questions he had about the company when it comes to some of the claims they made about manufacturing, and just how it didn't line up with what the rest of the industry, or what he understood as someone who worked in that industry. From there, I started following the trail. You looked at the Alien Dreadnought factory that was promised. We've seen Tesla walk that back a little bit when it comes to their manufacturing, and it's had some issues. They made some aggressive claims about their capabilities that haven't necessarily lined up to what the industry has done in the past. These are people that are very smart, very intelligent people, whose job it is to optimize these things as best as they can. When you saw Tesla move in and do some of these things, they didn't quite line up. 

But I never took a position in this company long or short until late February, early March of this year. You saw the issues with manufacturing. They said they'd reached 10,000 vehicles a week. Never quite got to that level. But if people were going to buy the car, it doesn't really matter. They'd turned profits in Q3 and Q4. But, you went into the start of this year, and you started to see significant price cuts. And for a long period of time, Elon Musk had said, "We are going to sell cars at a price, and we're not going to cut prices like traditional automakers." And they'd begun to change their tune on that. There'd been a number of layoffs. You'd seen Musk talking on, I think it was Axios, saying they were single-digit weeks away from bankruptcy in the fall. There's just a lot of red flags there. And as you saw the demand start to turn down, it didn't seem to me that there was a clear path out for the company. Right after that, of course, you saw all the store closures and those sorts of things. 

The question for me has just been whether they can make that jump from the luxury small market they had with the S and X into a mass market in a way that's going to be profitable, that they can deliver reliable vehicles and services that people expect. There's been a duality there. Consumer Reports, their annual auto reliability survey ranked Tesla 27 out of 28 brands, and yet Tesla's in the No. 1 position when it comes to overall customer satisfaction. You look at their services, people are very happy with their mobile service, but you've seen reports of folks that are unable to get in touch with service centers, and that's caused some issues. That's been the source of why I've had some skepticism around this company. That's where I'm at and why I decided to go short. 

Any thoughts on those concerns as someone who owns the stock, Brian?

Feroldi: Oh, yeah, there are numerous yellow to reddish flags, depending on your view. I will say, as someone that has owned and followed this company for the last seven years, the last two years in particular have been the most excruciating time to be a bull. There has been an almost never-ending string of negative announcements. We've seen high level executive departures. We've seen them push back dates. We've seen them say that they were going to be profitable, and that didn't show up. It's definitely been a trying time to be a bull. 

But for me, I will say that I am still a bull on this company. I view this as an asymmetric bet. If this company can do what they say that they can do, multifactor returns, I believe, are possible from here. If they can't do what they say they're going to do, which is a very real possibility, the short thesis could be very correct here. Hence why this is such a divisive stock.

Sciple: Right. And to date, depending on how you look at it, they have achieved incredible growth when it comes to delivery of vehicles with the Model 3. However, the promises that sooner or later that's going to drop to the bottom line have continued to be pushed out. At some point, they have to be profitable. But we'll see. 

Let's look at the most recent earnings we just got back in the past couple of weeks, their Q2. This continues what you can say is the duality of this company. You had record deliveries of 95,000 plus cars. However, you saw revenue down relative to the previous record delivery, which was Q4 in the previous year. Profits also down. Lost $400 million vs. that previous record delivery quarter, where they made about $140 million. When you take a look at those numbers, what stood out to you, Brian?

Feroldi: I view the Q4 2018 as definitely a fascinating quarter from a number of reasons. I think it was very clear that demand did get pulled forward, given the tax credit that was coming off, and their record numbers, they could not be maintained going into the first quarter. That was certainly disappointing to see as a bull. 

If you do look at their most recent quarter, we did see 44% growth sequentially and 60% up year over year. But as you mentioned, despite posting record deliveries, revenue was not a record. The answer to that question is because the average selling price on the vehicles is falling for two main factors. First off, S and X demand has not been as robust as I think management was initially targeting. I think it's clear if you look at the S and X numbers that the Model 3 is cannibalizing sales of those vehicles at a much higher rate than they initially assumed. I think that management was assuming that S and X would be in a steady state and Model 3 would be additives, but it's pretty clear that some consumers are choosing to trade down. S and X are much more mature products, and have a much higher gross margin than Model 3 does while it's ramping up. I think that's a big reason why profits and cash flow have not been as robust as Elon basically said it was. That is certainly something for investors to watch moving forward.

Sciple: Sure. The S and X were the traditional vehicles that the company had had before the Model 3 came out. Higher margin, higher average selling price. The two year run rate is about 25,000 units a quarter. Last quarter, 12,500. This quarter, looking at 17,650. A little bit of a bump up. We had this Raven upgrade that increased their range. You had some additional promotional activity. I think they made Ludicrous Mode free to returning buyers of the S and X. You had free supercharging being added. You see a lot of levers being pulled there to drive demand. But, again, if you're looking year over year, you're seeing a big increase when it comes to deliveries. The question mark is, when we come to next quarter, and they lap that Model 3 growth ramp, what is the narrative going to look like with this company? To be seen. Next quarter, we'll start to lap where that big bump-up in growth is. Any extra thoughts there, Brian, before we move on?

Feroldi: Yeah, I think that's completely right. The questions that are in the air right now for investors are, as you said, what's going to happen when we do lap that big jump? Is S and X demand permanently impaired? Or is it temporarily impaired? Those are questions that we do not have clear answers to at this point. The next let's say 18 months are going to continue to be extremely excruciating, potentially, or could really turn the narrative around. We will see.

Sciple: Sure. If you look at past trends, that Q4 to Q1 tax credit pull-forward definitely had a meaningful impact on demand. We saw at the end of Q2, we had another tax credit cliff. It's to be determined how much of a pull-forward will be there again. But that's what we'll be watching next quarter. 

The other big thing, we saw a $400 million loss in the quarter, but Tesla reported positive free cash flow of $614 million. Some of that is due to selling down a significant amount of inventory. Inventory was about a $450 million source of cash. If you look at their capex, their capex has continued to decline. In Q4 of 2018, capex minus depreciation and amortization was about flat, and that's continued to go down. Now, capex is below depreciation and amortization, which, for a high fixed cost company, is a concern. Accounts payable have continued to be stretched. You had an increase in deliveries for the quarter, where you would expect to incur higher rate of bills, however, $40 million less use of cash in this quarter than the previous quarter. So, there's some question marks when it comes to spending less on capex and selling down inventory, what the source of that free cash flow was. But, again, $614 million of free cash flow. Big question mark for this company was where they were going to generate cash to be able to pay down the debt maturities they have coming here in October. Any thoughts on that free cash flow number? What stands out to you, Brian?

Feroldi: Oh, yeah, when you dig into the numbers, I think it becomes pretty clear that Tesla did everything in its power to make it look like it had as much free cash flow as possible toward the end of the quarter, and it's very likely that a bunch of those payments were made as soon as the quarter ended. That's really not all that surprising to see, given that this company, everyone's putting everything under the microscope here and they're desperate to show net income and free cash flow to turn that narrative around. I think you did a great job of laying out that their free cash flow was positive $614 million, but many of those sources are not going to be repeatable. That's not something that can go on forever. Eventually, they will have to show free cash flow solely from operations, and not for moving around working capital. That's a big question mark for investors in the next couple of quarters -- can they produce positive free cash flow and positive net income without changing working capital? That's an unknown at this point.

Sciple: Right. Again, to be seen. We'll see how demand shakes out moving forward and how, as they continue to move into new markets, this China factory -- and that's something we'll talk about later on. We'll see how things play out. 

The other big news from the quarter is the departure of JB Straubel. He actually had a longer tenure at Tesla than Elon. He's been listed as a co-founder of the company, chief technical officer, and really spearheaded the battery initiatives and the supercharger network of the company. Had been a visionary when it comes to that part of the business. This continues a trend of executive departures over the past year and a half or so. You've had two general counsels leave, CFO depart, chief accounting officer leave after less than a month, chief information officer leave after less than a year, chief people officer leave after less than a year. You had 10% of the Autopilot team leave following Autonomy Day, including the head of the Autopilot team. When you look at the departure of Straubel and the executive departures that have taken in place over the past 18 months, what are your thoughts? Obviously, Elon's a very difficult person to work through, in that this has been a trend over time, but you've got to have people below Elon that do some of this work as well.

Feroldi: Oh, yes. I will say that the JB Straubel departure certainly took me off of guard. As you've pointed out, there has been a number of turnover in the executive ranks here for many years. There's no doubt in my mind that Elon must be unbelievably difficult to work for. So, the fact that JB was someone that was there so consistently over the years, this definitely took me aback. I think he'll be a huge loss for the company. 

It did say that JB will still be involved with the company at the board level, or a high level, executive level, or as a consultant. So he's not completely leaving. He will still have some touch with the company. But he's definitely stepping back from the day to day. I did read a report that he is actually going to be spending more time on a new company called Redwood Materials, which I believe is focused on recycling --

Sciple: Yeah, battery recycling.

Feroldi: Yeah, battery recycling. That could be something that he just wanted to do, he felt it was the appropriate time; or, it could be a sign of more troubling things going on. I don't have a lot of insight other than to say, he will be missed. He's a genius. There's no doubt.

Sciple: Yeah. This is one of those where, folks who had been bearish on the company had been suggesting that this was going to happen for a while. He had begun a stock selling plan back in November of last year and continued that plan even as the stock had declined. This past week, I believe he registered another five-figure amount of shares for sale. But, again, if he's funding this new initiative, and this new initiative is in battery recycling, this battery recycling initiative is going to be doing business with Tesla, who knows? There's a chance that there are some positive things here. The question is just, why are these people departing the company so quickly and selling stock, given that it's at a multi-year bottom? 

Elon is selling the story that the company's about to turn up. We'll just have to see. One of the parts of that story is this China Gigafactory that is beginning to come up and running. They hope to have production beginning before the end of this year. In the 10-Q this quarter, we saw the terms that they're going to have to maintain as part of that factory lease. They need to spend $2 billion in capex in China over the next five years, and they are required to generate $320 million in annual tax revenue by 2023, which I believe is $1.3 billion in pre-tax profits in China by 2023 assuming a 25% tax rate, in a market that's significantly more competitive than the U.S., where they have had some issues making money going forward. 

Obviously, you look at the opportunity from this China Gigafactory and these terms that they've got, what are your thoughts on how Tesla can use that moving forward to continue to drive growth for the business and meet these obligations?

Feroldi: Oh, yeah, there's no doubt that there's a lot riding on the China factory. Tesla is clearly moving into that market because it is the biggest EV market in the world. So far, they're having to pay huge tariffs when they sell into that market from their California factory. So, providing a factory to avoid those tariffs and have a local source makes complete sense. You did point out that there are some terms that need to be met, otherwise the company could be met with penalties. I think that if Elon can deliver on what he says and get ramped up, I would guess that the company would have no problems hitting those. But there's a question, which is, can the Tesla brand go into China successfully and compete in a very competitive market? We don't have a lot of answers about that, so this remains a big bet for the company. Again, it's another question we don't have an answer to.

Sciple: They already sell 35,000 Model 3s per year in China. Getting around those tariffs, you're going to see a 15% price decline, at least, when we look at tariffs. We'll see how much more demand that drives as the prices are driven down. Again, if they don't meet those obligations, they lose the China factory in 2023. One wildcard right now is, the current climate between the U.S. and China is very unfortunate. It's a tough time to be going to do business over there. Of course, everybody who does business in China is having to deal with this right now. Tesla is no exception. 

The other big future driver for this company that the company raised money on back in May with this Autonomy Day is that Tesla is hoping to deliver full self-driving capability to all of its vehicles. Elon had targeted by the end of this year. We'll see how those targets play out. When you look at the autonomy opportunity for Tesla, how are you handicapping when you expect that and the opportunity it drives for the company?

Feroldi: Well, when it comes to handicapping anything getting out there, whatever Elon Musk says, you basically have to add at least six months or a year to. He says they're going to be, I believe, feature complete by the end of 2019 and start to roll it out next year. I would guess that's going to be a hyper-aggressive schedule, as usual, so you'll probably actually see this out there in 2021, 2022. Investors need to know that this is a crucial development for the company. Elon has made it clear that autonomy is a major focus of the business, and they have a huge amount of competitors. There are dozens of companies around the world, many of them with billions of dollars in capital, that are throwing money to win the race to be the first company to have autonomy. 

Now, Tesla, I believe, is in a unique position in that they have a massive amount of data that they're pulling in from their fleet already, and they also are vertically integrated. They're actually building and selling the cars themselves. Earlier this year, they announced that they develop their own internal chip that's going to be powering their cars. It's possible that could be a competitive advantage for them. 

But, winning the race to be the first with a working autonomous vehicle on the market is crucial, I believe, for the company at this point if they want to maintain a lead. Once that becomes available and goes out to the general public, and anybody can, say, pull up their app on their phone and order a Tesla to drive them around, getting there first and becoming the first to market to have enough scale to have that go everywhere, that's crucial. So, this is something that investors need to keep a keen eye on.

Sciple: I also have a close friend who is in the autonomy area, I've had had the chance to speak to some folks there. My question marks here, it's similar to what I had with manufacturing, in that this is a very competitive industry, with a large number of very smart people working on this problem, with massive amounts of funding from SoftBank, Google has been throwing a lot of money into this, and others. And Tesla is taking an approach that much of the industry, including people who have previously left Tesla's Autopilot division, say is just not possible at this current time. No use of LIDAR, no geofence when it comes to being able to operate under all conditions. The people who know much more than me about this issue have suggested this is a very big long shot. Part of the reason Tesla has to take this path is that when you've sold a vehicle promising full self-driving capability to people that live all over the world, in all kinds of different places, you can't take a geofenced approach when you're selling that product. Likewise with LIDAR, when you're selling a product to a retail customer, you can't put a sensor on a vehicle that's going to cost $10,000 per sensor, given that you have to cut prices to drive demand as it is. So, there are some characteristics of Tesla as a business and the way they're structured that limit its ability to take the autonomy approach that the rest of the industry takes. 

They're rushing to get first to market. If you can be the first to market and deliver a product that is reliable and safe, that is a massive competitive advantage. However, if, because you have been selling this product for a number of years, and you have short sellers on your neck, and you need to show profits and realize this revenue of the deposits you've taken for full self-driving, you rush out a product before it is ready to go to market, it's a really dangerous position to put yourself in when it comes to liability, when it comes to trust in your brand. So, it is to be seen. It's a difficult problem. Tesla's taking a different approach to the rest of the market. They have access to real-world data that other folks probably can't match. But it's a question of whether their approach is going to play out.

From the information I've been able to see, I believe that it's very much a long shot. But, if it works out, it is a massive, massive opportunity. We'll just have to see. Any last thoughts on autonomy before we move on, Brian?

Feroldi: No, I think that's right. Google is obviously a huge player in this market. We've even heard, Baidu, for example, is doing great things in China, to say nothing of Uber and DiDi and literally dozens of other companies. I believe that the autonomy market is going to be potentially a winner-take-most market, so being first with a vehicle that is both safe and reliable is going to be a huge challenge for the industry in general. If Tesla can get there, then I completely agree that it will be a massive advantage for them. But you have to have basically belief in this case that management is right that their approach, which is different than the industry, is going to be proven correct. So far, we don't know if that is the way to go. But we will have to see.

Sciple: Gotta have faith. Last thing, you look at their cash balance, they're showing a $5 billion cash balance this quarter. There's some evidence as well there, similar to the free cash flow, it's not quite as high as maybe they had shown. If you take a look at their interest income, it suggests that they carried about $1.7 to $1.8 billion in cash during the quarter. If you look at their cash and money market funds, about $1.7 billion. They had $1.7 billion in debt repayments despite no maturing bonds in the quarter, which suggests they were drawing down their asset backed line during the quarter. That's suggested by their asset backed credit line only being down slightly vs. the first quarter despite a $500 million inventory sell-down. And, you see a continuing rolling of a SolarCity note. They had a $180 million Solar City note due in 2018 that they've continued rolling from quarter to quarter. They've paid off a little bit. There's $164 million still outstanding. But the question is, if you have such a high cash balance, why are you continuing to roll this less than $200 million debt? You look at their 2025 bonds, they're trading at $86 vs. $100 par. So, there appears to be some issues when you look at the debt market. 

When you see this debt coming due in October, I think it's another about $600 million due, profits really need to come from this company soon to be able to support these payments. When you take a look at the company going forward, where should we be looking for the profits and sustainable cash flow to come from to support these debt payments going forward? 

Feroldi: The obvious answer there is from operations. They have to produce and sell cars and make money on them. That's what the near-term and long-term future hinge on. Musk has said that they will become profitable and cash flow positive -- I believe a couple of quarters ago, he said all quarters moving forward. And so far, he has not delivered on that promise. I think the next earnings report, Q3 of this year, will be a pivotal quarter to really say that, yes, this is the profits, and we can produce them from selling vehicles moving forward, or not. As you mentioned, there are some debt payments coming down the road, and their cash balance probably was taken down significantly right after the quarter to meet some of their near-term obligations. So, it's going to have to come from operations, period.

Sciple: Yeah. As we look forward, any predictions or any ideas going forward of what you'll be watching as an investor when it comes to this business, what we should be looking for when it comes to those operations turning the corner?

Feroldi: Yeah. I think over the next year, the big question that this company has to answer is, can they build enough Model 3s and have enough demand to fund the business internally? S and X are both nice, but they will be overwhelmed by the sheer volume of the Model 3. The other question is, will that be enough to fund the development of all their other pipeline of projects? The next big one for investors to look forward to is the Model Y, but they've also said that they're going to be rolling out the Tesla Semi, the pickup truck, they have a couple of other things in the burner that they have hinted at that they haven't even released. Funding all those things and getting those to market will require capital, and Model 3 is going to need to be the primary driver of that. Investors really need to keep an eye on Model 3 deliveries and gross margins. Are they big enough to get this company to profitability and free cash flow? Thus far, we haven't seen that they've been able to do that. The next two quarters, we should have a much better idea.

Sciple: Yeah. A lot of the same themes is what I'm going to be watching. When it comes to the Model Y, where they're going to produce that. There's been some questions about how much space they have in their factory to install the Model Y line and begin production. Given the declining S and X sales, do we see some of that line being repurposed for the Y? If so, that'll tell you something about where S and X demand are moving forward. Obviously going to be watching the debt repayment coming due in October. How is the company able to absorb that? We had previous debt repayments back in the spring, and we saw a capital raise soon after that. Hopefully, the company can continue to generate cash flow to not need to tap the capital markets. 

As I mentioned previously, we're lapping the Model 3 production ramp up as we come into Q3. I am expecting to see declining deliveries, declining revenues, declining profits relative to that time. However, if the company is able to prove me wrong, that busts the short thesis. Again, if the company is able to deliver what they said when it comes to autonomy, really at any point between now and this time next year, any short thesis in this company is busted. I don't think that is going to take place, but we'll see.

Any last thoughts before we hit the road, Brian?

Feroldi: Yeah. Just to give listeners the framework that I use when I think about this company, for perspective here, I have been a Tesla bull for many years now, but even today, this stock represents about 2% of my real-world world portfolio. I'm happy with that percentage because I think the chances of multi-bagging from here could happen, but the odds of believing that happening, there's a lot of things that have to go right. The chances of that happening are probably low in the grand scheme of things based on the information that I have today. It's possible, but I don't think it's greater than 50% or anything like that. There is a real chance here that this company could be in financial trouble if it can't fund all its near and long term obligations and if demand for Y isn't as strong as we need it to be and if they have problems meeting demand in China and all those other areas, or if they fall behind in the autonomy game. There are a lot of things that need to go right from here moving forward for Tesla to be a successful investment. I'm comfortable with those risks given that it is such a small percentage of my portfolio, but this is a very high-risk stock, even from today.

Sciple: Yeah, listeners, exactly what Brian said. To own this stock today, you have to calculate, what is the probability that they're successful? And how much return can I get? And compare that to, what is the probability that this company does not work out? What is the potential loss that I could face? If you believe that number is significantly positive, you should own this stock. If you believe that number is significantly negative, like I do, you'll be short this stock. If you're somewhere in the middle, maybe you should just be watching from the sidelines, and watching all of us bicker back and forth. 

Feroldi: [laughs] At least we have fun bickering about it, right?

Sciple: Yeah, exactly. And we're addicted to it at this point, so we'll keep watching it. 

Brian, thanks for coming on the show! Hopefully this is a more sober discussion of this company than are available in other places.

Feroldi: Nick, thanks for having me! Great to be here!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Brian Feroldi, I'm Nick Sciple. Thanks for listening and Fool on!