The market hasn't been particularly happy with Tesla's (TSLA 0.07%) third-quarter 2022 earnings report, released last week. The company continued to grow, but margins were down, and results didn't meet analyst expectations. That situation generally leads to a falling stock price.
What stuck out in the report was a long discussion about Tesla's inventory and how it's changing delivery practices in the future. Management acknowledged that they've been rushing deliveries at the end of the quarter to maximize revenue and earnings, which has hidden some of the inventory building during the quarter. As that will change in the future, some red flags are emerging.
Image source: Tesla.
An earnings report full of red flags
Last week, I highlighted that inventory challenges are one thing investors need to watch out for during this earnings season. Rising inventory and falling margins could indicate trouble, particularly for manufacturing companies. I noticed three red flags in Tesla's earnings report, all related to inventory.
- First Red Flag: Inventory at Tesla is rising quickly. It was $10.3 billion in the third quarter of 2022, up from $8.1 billion a quarter ago and $5.2 billion a year ago.
- Second Red Flag: Tesla's gross margin fell from 30.5% a year ago to 27.9% in the third quarter of 2022. Falling margins are a sign that companies don't have pricing power, and when combined with rising inventories, it's a potential problem for the entire auto industry.
- Third Red Flag: Tesla openly admitted it has been managing the balance sheet to quarterly results and will stop doing so, explicitly telling investors that inventory will rise sharply as a result.
In isolation, none of these trends are worth being worried about. But together they are a concern for a manufacturing company. And if a recession is indeed on the horizon, conditions could get a lot worse before they get better.
Tesla's inventory saga
There's long been speculation that Tesla played games with inventory to make its numbers look good each quarter. But this earnings report outlined the lengths the company goes to deliver as much inventory as possible right before the end of the quarter. This means that Tesla has been managing its balance sheet to look artificially better at quarter-end than at any other point in the quarter.
CFO Zachary Kirkhorn said on the quarterly conference call, "roughly two-thirds of our Q3 deliveries occurred in September and one-third in the final two weeks."
To put that into perspective, this means that $7.2 billion of revenue was generated in the final two weeks of the quarter. Assuming deliveries, revenue, and cash paid for products happened at the same time, Tesla had closer to $13.9 billion in cash on Sept. 23, 2022, as opposed to the $21.1 billion in cash reported on Sept. 20, 2022. Cash at the end of August may have been under $10 billion, based on the amount of inventory that would have been built up.
What impact will a smoothing out of deliveries have on the balance sheet? The figure below was in the Q3 2022 earnings letter, and while it doesn't have a scale on the y-axis, we can infer that Tesla will have a higher level of inventory in the future than it does today.
Image source: Tesla.
No matter how you look at it, Tesla is telling investors that it will have higher reported inventory at the end of the quarter in future quarters. That likely means less cash on the balance sheet, which was always one of the selling points for Tesla stock.
Why inventory could be a reason for concern
There are three main reasons to worry about inventory at any company:
- Increasing inventory pulls assets from other parts of the business. Potential impact: Less cash.
- Rising inventory can indicate demand does not match supply, and discounting may be necessary to move inventory through the supply chain. Potential impact: Lower margins.
- Tesla still expects to grow about 50% per year, but rising inventory and falling margins indicate there may not be the demand for that kind of growth from consumers. Potential impact: Slower growth.
We already see No. 1 and No. 2 happening today, and Tesla is telling us inventory will continue to increase. If margins continue to fall, that could mean not only profits but growth are the next shoes to drop.
Tesla benefited from the auto industry's slow adoption of electric vehicles, the chip shortage, and a better business model for years, but the competition may be catching up just as a global economic slowdown hits demand for expensive vehicles. These are choppy waters Tesla hasn't navigated before, and that's why Tesla's inventory revelations were such a shock.
Over the next few quarters, we'll find out if these red flags become bigger problems for Tesla.
