A Closer Look at Tesla's Q2 Results

Telsa's (TSLA 1.14%) second-quarter 2019 looked good on the surface. Deliveries and revenue were both up significantly year over year. The company generated positive free cash flow and ended the quarter with its highest cash balance ever. However, the results were far from flawless.

In this weeks episode of Industry Focus: Energy, host Nick Sciple and fool.com contributor Brian Feroldi dig into the details to shed some light on why Tesla's results might not be as strong as they appear.

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: 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?

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.