In this episode of Industry Focus: Energy, host Nick Sciple and analysts Jim Mueller and Jim Gillies get together to talk about Tesla's (TSLA 1.70%) surprising earnings news and the huge rally it caused in the stock. Tune in to hear what Tesla reported about its metrics, software progress, and more -- and why investors should take it with a grain of salt. Learn what numbers and statements from the conference call are the most puzzling and why, when we will get more concrete info on what's really going on here, why Tesla's capital expenditure and debt trends should raise some yellow flags for investors, and more.
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This video was recorded on Oct. 24, 2019.
Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today's Thursday, October 24th, and we're breaking down Tesla earnings. I'm your host, Nick Sciple. Today I'm joined by Motley Fool analysts Jim Gillies and Jim Mueller. How's it going, guys?
Jim Mueller: Hey, Nick! How are you?
Jim Gillies: Glad to be here!
Sciple: Jim is joining us from Canada via Skype. If you hear a little bit of echoing in the background, that might be technical stuff. But, yeah, we're talking about Tesla today, the big news of the day. Tesla shook Wall Street last night, reporting a quarterly profit of $1.86 per share. Crushed consensus expectations for a loss of $0.23 a share. That, plus a surprising free cash flow sent the stock up more than 20% after hours. We'll dive into details in a second. But just off the top, guys, what was your immediate reaction to seeing these numbers come out? We'll go Mueller first.
Mueller: [laughs] Well, my first word, I can't say. It was surprising. I expected them to beat estimates, but I did not expect them to post an actual profit, no.
Gillies: I would say my reaction could be summed up as stunned curiosity. There was a lot in there, and there's a lot to come out. But I think they addressed the biggest problem facing them coming into the quarter, which we'll get to.
Sciple: Sure. One of the biggest doubts around the company was whether they could get around this this Model 3 ramp, which they're lapping this quarter, and show some positive signs of hitting profitability and sustainability. Revenue was actually down slightly quarter over quarter, down about 8% year over year. Auto sales down 12.5% year over year, and that's despite record deliveries. When we see record deliveries of vehicles and revenues coming down slightly, what's been driving that declining revenues for the company?
Mueller: That's obviously lower average selling price with the cars. They're selling fewer of their Model S and X cars, their high-end, high-profit cars. They're selling more of the Model 3s. That mix shift explains part of it.
The other part of it is probably Tesla continuing to lower the selling price for the Model 3, for whatever reason. They say it's because it's still profitable, and they're passing on savings to customers, and things like that. But if that means less revenue and less cash flow coming through the door -- something you didn't highlight but is also true -- then it's something that analysts all over Wall Street, including here at Fool HQ, are going to try to dig in deeper and figure out what's going on.
Sciple: Musk mentioned on the call, he said the S and X they're making for "sentimental reasons" at this point. Those continue to trend down. However, Model 3 deliveries up 42% year over year. One thing the company does call out is that they tripled their percentage of leased vehicles in the quarter. That contributed somewhat to the revenue decline.
When we see that increase in profitability on declining revenues, what that really means is that the company was successful in cutting costs, and it increased margins, and it was able to generate that profitability. To call out a number there, Tesla's operating expenses were the lowest they've ever had since the launch of the Model 3, and that drove up gross margin. As we look at the numbers and drill into those a little bit, do we have any handle on what levers Tesla was able to pull to bring those costs down this quarter and show that profit?
Gillies: Just to step a little bit back before we try to answer that question -- it's a deceptively complicated question. I don't think we're going to be able to really answer it terribly well, but we'll give it a shot. Coming into this quarter, the Street new, and certainly Tesla internally knew, that revenue year over year and quarter over quarter was probably going to be down, even as they delivered record number of vehicles. In part, that is because of what Jim has just said -- the mix shift from the S and X over to the 3. It's in part due to the lower average selling prices on the 3s. So, you were set up for revenue to be down. As Tesla is perceived as a growth company, and your top line is going the wrong direction, as you've already called out -- automotive was down about 12% -- that's a mismatch. So, you knew that they were going to need something to... I don't want to say distract, that's an implicitly negative word. But, they needed to tell a different story, because the story they're going to tell is, "Well, our revenue rolled over." So, the story I think they were telling this quarter was, "Yes, we didn't grow this quarter, but look at the growth we're going to have going forward." There's multiple examples of that.
And then the second piece is this profitability, this sudden surprise profitability. What they did here, for example, the cost of the vehicles, cost of goods sold, they improved something like $230 million from last quarter. The cost of goods sold per car has gone down, which is good if it's real. Now, we don't have enough granularity into it yet. Probably won't for a few weeks, until the quarterly report is delivered. Probably not until the annual report is delivered. But things like, if they change, say, the depreciation assumption on the tooling that they use to make a car, that would result in lower depreciation expense, which falls part in the cost of goods sold, which then, cost goes down, profitability goes up. Their R&D was flat, certainly better than recent quarters. Their SG&A, sales, general, and administrative expenses, that was better. Below the operating line, they had a benefit on the other income, claiming it was foreign exchange related. All of these things are surprising. They fell Tesla's way in this quarter. But add it all together, and you've got over half a billion dollars of improvements to profitability. Even when you have that, even though overall revenue down 1% quarter over quarter, and, as you said, 8% year over year, when the income statement falls out of the spreadsheet, you end up with a profit.
We need to get into the granularity and look at some of it. But certainly, at first pass, and look at the market reaction today, certainly the market reaction is very strong and quite surprised by it -- delighted by it, I should say. But we won't know the full extent of how things were done probably for a few weeks, if not until the start of next year.
Sciple: Sure, yeah. Just to hammer those numbers home a little bit, SG&A, lowest share of revenue since the end of 2018. Lowest in absolute terms since the second quarter of 2017. That's when Tesla sold about a quarter of the vehicles they sell currently. So, they've really been able to get those costs down significantly.
Any indications on how sustainable these cost cuts may be going forward, whether we can see this profitability continue quarter over quarter and these cost cuts are sustainable?
Mueller: If they changed the depreciation schedule for the equipment that they use to make the cars, that's going to be continued forward, and is going to be a lasting savings in the costs. But if they're doing it because they're not paying for the supplies they're using to build the cars, that's probably not sustainable.
Gillies: To add to that, Nick, what Jim just said, depreciation is, of course, a non-cash expense. So, if they did change the depreciation schedule, for example -- and we don't know if they have, but this is as an example. If that was done, what that means is that the accounting profit would be improved; but from a cash flow perspective, you paid for the tooling three and five years ago, and then depreciation is what it is. It's not going to improve the cash thing. But, on the cash flow side, you would have a bit of a different argument or a different concern.
The other thing, though, is what Jim talks about, and it also ties into what I've just said, if we're making the S and X cars for, they called them "sentimental reasons" now -- which saddens me, because I really like the S -- if they're making them for more sentimental reasons, and they're not the profit drivers expected going forward, are they using, say, old tooling, perhaps fully depreciated tooling, there? If they are fully depreciated, then the accounting margins on those cars will be stronger because they're not spending a lot on depreciation and amortization expense. If they're just making them for sentimental reasons, are they building, say, new stamping dies or whatever for them? We don't know. We're not internal. But there are some things that you can do to boost these that look sustainable.
I'm more curious, frankly -- you asked about sustainable cost cuts. I look at the R&D not going anywhere, even though we're supposedly ramping up the Model Y earlier than projected.
Mueller: And don't forget the semi.
Gillies: Yeah, and the semi. And the pickup. And probably a motorcycle at some point. The other thing about that is, they're constantly doing their software updates, the full self-driving, the autopilot, that sort of thing. Presumably, some of those costs for doing that are dropping into R&D, and yet R&D, we're not seeing it move. So, they're not spending a lot there. They're not spending what we thought they were going to spend on capital expenses. SG&A, if they have spent less, you hope it's a sustainable savings, because, frankly, Tesla was a little bloated in that area before. If that's sustainable, that could be great. But we got one quarter, and we don't have the quarterly report. We're going to need to see that and try to suss out where those savings have come from.
Certainly, if you read the conference call -- for anyone who's read a Tesla conference call transcript, or listened to it, and this is neither a good nor bad thing, it's just a thing, Tesla is optimistic about everything, always. Of course, everything that was said by the various members of management on the call was, "Yes, everything is sustainable. We're doing so well on cost-cutting. We're doing so well on capital efficiency." And maybe they are. But when someone is so perpetually on one side of the equation, maybe it's just me, but I have a tendency to discount that a little bit. It's the same way if someone's perennially negative. Like, well, things are never as bad as you think. So, I would like independent verification of some of these cost savings. Or, alternatively, give me a couple of more quarters of this, and show me that you're staying at that level without any damage to your business, and I'm going to believe you, I'm going to believe your optimism.
Sciple: Sure. Jim Mueller, any last thoughts?
Mueller: I was going to play off of something Jim said about cash flow, if you're ready to move into that direction.
Sciple: We'll cover cash flow on the back half of the show. For what it's worth, on earnings, Tesla's calling for positive net income going forward with temporary exceptions around the launch of new products.
OK, the other big number from Tesla's earnings report last night was this free cash flow number of $371 million. Also took Wall Street, most observers, by surprise. Y'all mentioned capex earlier. When you drill down into the source of this free cash flow, do we have any indications on where that's being generated? Operating cash was actually down quarter over quarter, so this is another instance of where the cash flow moving out the door is more driving this free cash flow than bring in additional cash flow vs. previous quarters.
Mueller: Before diving into the weeds a little bit, I'll put some numbers on what you just said. Quarter over quarter, it went from $864 million of cash flow from operations down to $756 million. That's about a $108 million drop in cash flow from operations. They ramped up capex a little bit from $250 million spent last quarter to $385 million spent this quarter. Combined, the two numbers make free cash flow a little bit smaller quarter over quarter, but also year over year. Last year, in the third quarter of '18, they had well over $800 million, almost $900 million of free cash flow.
The problem I see with this is that they're not even keeping up with the depreciation expenses that they have on their books in the income, which is part of what's helping make the margins look better. The $530 million worth of depreciation on all their capital equipment was balanced by only $385 million of new investment in capital equipment this quarter. That's not sustainable, especially for a growing company going into the future.
Last year through this date, for the three quarters, they had $1.4 billion worth of depreciation and amortization, and they had capex of $1.8 billion. So, they were investing not only to cover what they were losing on depreciation, but also investing new equipment and new capital there. So far this year, they have $1.6 billion of depreciation, and only $900 million of capex, so they're not even keeping up with that number. That's fine in the short term, it's a decent source of cash in the short term, but it's not sustainable for the long term, especially given their growth plans of bringing out a Model Y, a pickup truck, and possibly a motorcycle, but we haven't heard any rumors about that.
Gillies: [laughs] The motorcycle's just me.
Sciple: It's worth noting, Tesla started out the year with a projection of $2.5 billion in expected capex, as Jim mentioned. Through three quarters, we're around $900 million in capex, so well behind that original guidance.
Mueller: The original guidance was $2.5 billion. Then, in the first quarter, they ramped that back to between $1.5 billion and $2 billion --
Gillies: Actually, it was $2 billion to $2.5 billion after Q1, and then $1.5 billion to $2 billion after Q2.
Mueller: So they've ramped it down twice this year. I don't believe they said anything about that this quarter.
Gillies: They didn't.
Mueller: The total is $915 million out of a minimum of $1.5 billion for the guidance, which means they're going to almost have to double their quarterly capex in the current quarter, Q4, just to meet the bottom end of that guidance. Given their lack of commentary about that, I'm not even sure they're going to reach that. Which is disappointing, but also scary if you're looking for long-term growth of this company.
Gillies: That's really just it, right? What is the guidance? The $2.5 billion, how did they make that? Are these guys good capital budgeters, is my question? I'm not being facetious. You started out saying, "We're going to spend this," and then you drop it, and you drop it, and now you grossly underperform where you said you'd be, and now you just abandon it.
What I said earlier, the theme that I saw in the quarter was how everyone knew the growth was going to roll over, including Tesla. Tesla obviously knows their growth is going to roll over. So, they have to tell a different story. If we had a bottle of scotch and about four hours, we could step through multiple places in the conference call and the presser where they talked about things that... I'm going to call them implicit growth promises. The company's giving you an implicit, "Yes, don't pay attention to our shortfall in growth in this quarter because the future is going to be better." Whether that's Elon saying that he thinks the Model Y is going to eventually outsell the S, X, and 3 combined, eventually. Of course, they haven't produced any Model Ys yet. That's an implicit growth promise. When they talk about, they think their three factories -- they're looking to build one in Europe -- that's going to triple their output. That's an implicit growth promise. They talk about this capex, to bring that back around to what Jim was just saying. They've grossly underperformed where they originally said they were going to spend. And then they actually talk about how that spending was primarily spent on Gigafactory Shanghai, Gigafactory 3, and on Model 3 tooling and what have you. So, implicit in that is, this capex is arguably one-time in nature, which means, in future, it will be lower still. And, because free cash flow is operating cash less capex, if capex is lower still in the future, that implies another implicit growth promise: there will be greater cash flow in the future. I could probably give you another five or 10 examples through the call.
And that's just the capex tech side of it. But then on the operating cash flow side, which is the starting number you go for free cash flow, there was a number of things in there that make you wonder what's going on. First off would be the higher depreciation.
Mueller: Jim, before you get too much further into that, I want to make one more point on the capex. The concern of comparing it to the D&A, the depreciation line, isn't because they have to spend that amount just to stay even. It's because this is real equipment, real mechanical equipment, whether it's robots or conveyor belts or what have you.
Mueller: And tooling that has normal wear and tear, has to have parts replaced, has to be repaired, has to be maintained and all that. And that's where the capex equaling the D&A line, that's the implicit assumption, is that they're maintaining their equipment. If, as you hypothesize, this is a one-time capex spend on their new lines, are they actually maintaining the equipment they have? If they aren't, what happens when that equipment eventually breaks, as all mechanical equipment eventually does? That's where my concern comes in.
Gillies: Yes, and to put some color on that, the rule of thumb is that a growing company -- and remember, Tesla wants the perception of a growth company -- a growing company is generally spending more on new capital, on capex, than they have done before, and they are seeing the depreciation and amortization, so the offset of the previous capital spent, that is generally less than the capital you're spending today, for various reasons. You're growing, and inflation and yada yada. But the really telling thing here is that Tesla through years 2009 through 2018, every year, capex less depreciation was positive. You would expect a growing number there. And for a number of years, it's between $150 million, $200 million, that kind of thing. Then you saw it ramp up in 2014, 2015, and 2016. It averaged about $700 million, $800 million a year more capex than depreciation. 2017, when they were spooling up for the Model 3 launch, they spent almost $3 billion, about $2.8 billion, on capex more than they got with depreciation charges. So they really spun up the flywheel in 2017. For the last four quarters now with Q3 2019, they're now negative to the tune of almost $600 million. This is starving the beast. Maybe they have gotten the supreme capital efficiency religion in the last four quarters. It's possible. But this a yellow flag. They see the starving themselves. And they claim that they're going to be more efficient going forward. And you wish them well. But that triggers my, "there's something going on here" concern.
And then, to flip back to the top, free cash flow was operating cash less capex. So we've dispensed with capex there. But on the operating cash flow, one of the things that happened in the quarter that drove the free cash flow up was, their payables went way up, to about $340 million more in accounts payable. Well, companies in the past have used this as a trick. Don't pay your bills before September 30th, so you retain the cash on your balance sheet. So, you say, "We're producing all this cash." Don't pay your bills. September 30th, quarter closes. October 1st, you pay your bills. But, you can show the cash on your balance sheet as of the end of the quarter, and you can show the cash as cash flow. This is a charge that's been leveled at Tesla a few times in the past. You've undoubtedly seen how, in any given quarter, they take the first couple of months and they meander along, and then there's always that big push in the final month. There was one in September, there was one in June, there was one in March. They push, push, push, and you'll see some form of a leaked email from inside Tesla, usually saying, "Hey, we can we can have a record quarter if we all pull together!" So, most of their stuff goes out in the last month. That would dovetail with, the "don't pay your bills until the following month," which then becomes into the next quarter. It's not sustainable unless you can keep on having that push.
That looks like maybe what happened here. There are some other things that make you raise the proverbial Spockian eyebrow. But those are the two things that I looked at. I think they're starving capex. At the same time, I think they are masterly managing their working capital.
Sciple: Yeah. Just to give Tesla a little bit of benefit of the doubt there, you can see how they could generate some capex efficiencies relative to the Model 3 --
Gillies: Oh, sure!
Sciple: -- because there were so many own goals and unforced errors during that rollout. They had to pull out a whole bunch of machinery because they made some mistakes on automation there. So, I think there's definitely going to be some increased efficiency in capex. But, to both of y'all's points, seeing capex for a capitally intensive business like Tesla that's in the manufacturing space, not meeting maintenance capex, so, not having your capex x equal depreciation and amortization, tends to be a negative sign.
But moving forward, we have the Model Y. Elon has called for volume production by summer 2020. We've mentioned before, the Shanghai Gigafactory. They think that's ahead of schedule. They want to announce a European Gigafactory for 2021. Elon has reiterated his intention to deliver feature-complete full self-driving by the end of 2020. Obviously, all these big plans moving forward. Going away, both of y'all, what is your biggest question facing Tesla moving forward?
Gillies: I have some questions. I got a lot of questions, frankly. But, you talked about the feature-complete full self-driving. That to me was another implicit growth promise. And he kind of backed away a little bit on the conference call. I'm not sure most people spotted that. They basically said, "Oh, yeah, we're going to have full self-driving by the end of next year." Feature-complete, you used the words there Nick, the appropriate words. Feature-complete. In other words, "Yeah, we think it'll work." But the regulatory bodies, the authorities, have to approve it. So, the implicit message there is, "Well, we'll be done, but if the authorities don't allow this to be legally used," and full self-driving, basically, your car does everything for you, and you have a robo taxi, and you do nothing while you're in the car, and you can have your robo taxi working at night making you some money. But if this doesn't happen, well, it's clearly the politicians and the bureaucrats who weren't going to let it happen. He's kind of, in one sense, another implicit growth process. "This is going to be cool when it happens." And let's face it, a car that could be a robo taxi would be pretty cool. But, as well, he's stepping away from that prior promise, which was the promise for the last capital raise, of full robo taxis by next year. If anyone's seen some of the videos of the smart summon, the car basically takes five minutes to go 200 feet. It looks like a giant Roomba in a parking lot. I'm skeptical that they'll ever be able to get that, frankly.
The other questions I have are, as you say, Nick, look, maybe there's some capital efficiency here. You know what? I think that's probable, frankly. It does speak to them maybe wasting some of the capex in the past then, frankly. But, whatever. That's then, and this is now. We remember back to the so-called miracle quarter, Q3 2018. Much like this quarter, they printed a surprise profit. They printed a surprise free cash flow number. The stock shot up. It looks a lot like this quarter. And we later found out that a lot of that miracle quarter was because they'd run some concessions to of their suppliers, most notably Panasonic, who supplies their battery cells. So, I'm curious. That's my big question. We've used the word sustainable a number of times in this podcast. The previous miracle quarter, in fact, was not sustainable, apparently. I'm curious to see if this one holds. I really am. As you guys know, I'm a big fan of electric vehicles and on the electrification of the vehicle fleet up there. You want these things to work. I don't really care about robo taxis, but you want the progression of electrification of the vehicle fleet to progress. And Tesla certainly is a big part of that. So you want to see them have success there. But there's enough that has me going, let's pull a Ronald Reagan and do the whole trust but verify kind of stance. Does that make any sense?
Sciple: Sure thing. Jim Mueller, last thoughts?
Mueller: I think my biggest question is how they're going to handle their debt. The debt load did come down a little bit --
Gillies: It did not. Sorry to break in here. Actually, that was something I wanted to talk about. Their cash went up $383 million, and they were touting how they had their cash go up. Their debt went up $373 million. So, they touted their cash increase on the balance sheet, but completely ignored that basically, their debt increase was the same amount. It was all smoke and mirrors. I'm looking at the spreadsheet right now, total debt went up $373 million.
Muller: Alright, then I must be misremembering what I was looking at.
Gillies: I wouldn't correct something else, but this is a factual number I'm staring at right now. Sorry!
Mueller: Fair enough, Jim. I trust you on the numbers. That still doesn't change my question -- how are they going to handle that debt going into the future? With that much debt, they've got a huge interest expense. Will they need to go to the capital markets again, is my biggest question, to continue funding. Given all that we've discussed about cash flow from operations and capex, and how they might be robbing the future Peter to pay the current Paul, will they need to actually go back to the capital markets? And, if they do, what terms would they be able to manage to get? We'll have to see about that.
Sciple: Jim Gillies, any thoughts there on the debt that you wanted to share with us?
Gillies: Yeah. I very much share Jim's interest and concern on the debt. Their debt did go up this quarter, as I said, and basically accounts for the entirety of the cash increase this quarter. But the promises that were made and in the press release, and in the conference call, and we've heard promises like this before -- they talk about the ongoing profitability, maybe around new product launches, maybe not. And they talk about full self-funding. They believe they should be able to sell-fund. Again, we've heard this from Tesla before. But to what Jim was just saying, if they're fully self-funding, then no, they shouldn't need to raise. So, for me, if they do go out and raise again -- and remember the last raise, in May, they said, "We're just going to put that cash on the balance sheet," essentially to have a buffer, and by all accounts, it's still there, although we can discuss that a little bit -- but, to me, almost, going out and doing another capital raise when they're now so capital efficient that they can starve their capex and do it less than D&A, when they're wringing so much costs out of their business... if they go out and raise capital, I think that's a profoundly negative sign, because everything they're saying says, "We don't need it."
Mueller: I just want to throw in, I found where I got my confusion from. I'm looking at S&P Capital IQ. The total debt of $13.3 billion vs. the end-of-year 2018 number of $13.8 billion. That's where I was thinking that it had come down a little bit.
Sciple: Sure. So, I think the big takeaway from this earnings report for Tesla is, obviously, incredible accomplishment, to be able to push out earnings against the main expectations of the market. However, when you drill into some of these numbers, questions still persist. As it's Tesla, we'll be following this all the time because it's everybody's favorite stock to follow, whether you're a big fan of it or whether you like to be skeptical of it. But next time we have more information to talk about this company, we'll have y'all on again soon to talk about it. Thanks for coming on, both of y'all!
Mueller: Thanks, Nick!
Gillies: Thanks for having me!
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 Jim Gillies and Jim Mueller, I'm Nick Sciple. Thanks for listening and Fool on!