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Is Tesla's profit built on an unsustainable house of cards?
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The past 30 years have featured no shortage of next-big-thing investment trends on Wall Street. Everything from the advent of the internet to the development of artificial intelligence (AI) has captivated investors' attention. But over the coming years, it's the rise of electric vehicles (EVs) that could drive some of the highest and most consistent growth.
Although the EV space is highly competitive, one company has become nothing short of a polarizing battleground between optimists and skeptics. I'm talking about Tesla (TSLA 0.01%), the world's largest auto stock by market cap.
While Tesla has ridden its first-mover advantages to phenomenal gains, there are some very clear reasons to completely avoid investing in this highflier.
The Model 3 is Tesla's flagship sedan. Image source: Tesla.
Before digging into Tesla's red flags, allow me to give the company credit where credit is due.
Tesla is the first automaker in well over a half-century to successfully grow from the ground up to mass production. More importantly, it's the only pure-play EV maker that's generating a profit on a recurring basis. Tesla has produced three consecutive years of profits, based on generally accepted accounting principles (GAAP), and is three-quarters of the way to a fourth straight year.
Tesla's balance sheet is also something to marvel at within the auto space. Traditionally, legacy automakers have relied on debt to finance various aspects of their production, expansion, and innovation. This has left many of the world's biggest auto manufacturers with a sizable amount of debt on their balance sheets.
Meanwhile, Tesla closed out the September quarter with nearly $26.1 billion in cash, cash equivalents, and investments compared to roughly $4.4 billion in current and long-term debt and finance leases. Tesla's financial flexibility is far superior to most of its competition, which is what allows CEO Elon Musk the confidence to expand production and aggressively innovate.
Additionally, Tesla is generating a profit from its ancillary operations. The company's third-quarter results show a "combined gross profit generation of over $0.5 [billion] in Q3" from its Energy Generation and Storage segment, along with Services and Other operations.
But this Wall Street darling has a glaring problem hiding in plain sight.
I know what you're probably thinking: "He's going to discuss the company's declining operating margin!" While you're correct, I'm not ready to touch on that subject just yet.
The far bigger worry for Tesla is how the company is generating its profits.
As a high-growth, industry-leading business with a market cap that's greater than virtually every other major automaker on a combined basis, the expectation would be that Tesla's core operations -- selling and leasing EVs -- are driving the bulk of its profit growth. After all, the bull thesis for years has been that Tesla's first-mover advantages and production efficiencies would allow it to produce EVs at a cheaper cost than legacy automakers, thus leading to a superior operating margin and a rapid ramp-up in production.
The September-ended quarter saw Tesla generate $2.045 billion in income before taxes. A whopping $554 million of this profit derived from automotive regulatory credits. Renewable energy credits are given by governments to Tesla for free, and the company is able to sell these credits at a 100% profit to other automakers who may be short of meeting certain carbon-offset requirements.
Another $282 million in Q3 pre-tax income can be traced to interest income on the company's abundant pile of cash. Don't get me wrong. I'm not in any way faulting Tesla or its management team for generating interest income on capital they have lying around. It's a smart move.
All told, that's $836 million of the company's $2.045 billion in pre-tax income that's derived from potentially unsustainable sources of profit that have absolutely nothing to do with selling or leasing EVs. In other words, 41% of the company's income before taxes has a pretty big asterisk next to it.
Image source: Getty Images.
In addition to the aforementioned 836 million reasons to be skeptical of Tesla stock, there are three even more prevalent reasons to shy away.
The first, as noted, is the company's rapidly declining operating margin. Tesla kicked off a price war with other EV makers earlier this year and has, in the process, reduced the selling price across its four production models (Model's 3, S, X, and Y) on more than a half-dozen occasions.
With Musk confirming that his company's pricing strategy is based on demand, these aggressive price cuts clearly signal that competition is picking up and Tesla's inventory levels are rising. That's not a good combination, and it perfectly explains why Tesla's operating margin has been more than halved (17.2% to 7.6%) over the past year.
The second prevalent reason to avoid Tesla stock is Elon Musk. Though he's viewed as a visionary by optimists, Musk has also proven to be a major liability for his company. He's drawn the ire of securities regulators on a handful of occasions and has made countless promises with regard to innovations that haven't been kept. Advances like "full autonomous driving" have been baked into Tesla's valuation, yet the company remains no closer today to moving past Level 2 autonomy than it has over the past five years.
The third prevalent reason to keep your distance from Tesla stock is its valuation. If Tesla were a high-growth company with a superior operating margin to its peers, perhaps a case could be made that it deserves an otherworldly premium. But at 68 times Wall Street's forecast earnings this year, a declining operating margin, and more than 40% of its income deriving from unsustainable sources that have nothing to do with the company's operating model, the company's valuation can't be justified.
While Tesla's history of innovation and first-mover advantages are bound to lure some investors, there are 836 million reasons why I won't be one of them.