Tesla (TSLA -1.11%) stock isn't flying as high as it was earlier this year. A combination of the overall stock market pullback and disappointing third-quarter results have caused Tesla's share price to sink close to 30% below its July high.
Investors were concerned with Tesla's shrinking profit in Q3, with net income plunging 44% year over year. The good news is that the company remains the most profitable electric-vehicle maker in the world. But what if Tesla saw $1.8 billion in profit evaporate? Here's how it could happen.
Tesla's earnings distortion
Earnings can be distorted. There often are unusual gains and losses in quarterly earnings reports that muddy the waters for investors trying to understand a given company's financial health.
Of course, this isn't an issue that only applies to Tesla. However, it's quite clear from a detailed analysis that Tesla's reported earnings are indeed distorted to some extent.
New Constructs is a leading investment research company that uses artificial intelligence (AI) to pore through quarterly reports with a fine-toothed comb. One of New Constructs' key goals is to determine what companies' core earnings are. Core earnings reveal what a business' normalized operating profitability is. Once core earnings are found, it's easy to calculate the earnings distortion by subtracting core earnings from reported earnings.
The chart shown below, which is based on an analysis performed by New Constructs, breaks down Tesla's earnings distortion for the trailing-12-month period ending on Sept. 30, 2023:
Data source: New Constructs trailing 12-month data through the quarter ending Sept. 30, 2023.
As you can see, more than 16% of Tesla's reported earnings are distorted. What's the main culprit? Automotive regulatory credits.
How $1.8 billion of Tesla's profit could evaporate
We need to understand how automotive regulatory credits work to see how roughly $1.8 billion of Tesla's profit could evaporate. So exactly what are these credits?
Governments across the world want to reduce carbon emissions. As a result, they incentivize companies to achieve this goal by giving carbon credits. Automotive regulatory credits are a special type of carbon credit that governments provide to automakers that sell vehicles that emit little or no carbon dioxide. These automakers can then sell their credits to rivals that don't meet government-specified thresholds.
For example, in California and at least 13 other U.S. states, auto manufacturers must produce a minimum percentage of zero-emission vehicles (ZEVs) based on the total number of vehicles sold in the state. Since all of Tesla's vehicles are ZEVs, the company receives plenty of credits that it can turn around and sell to other automakers at a 100% profit.
One way that Tesla's distorted profit related to automotive regulatory credits could largely or even completely go away is that governments could change their regulations. The good news for the company is that there aren't any signs of this happening in the near future.
However, there is a much more serious threat. As automakers increase their production of electric vehicles, the market for automotive regulatory credits will dry up. It's a matter of when not if this happens.
S&P Global predicts that there will be a "diminishing opportunity after 2025" for selling automotive regulatory credits in the European Union. It seems likely that the U.S. automotive regulatory credit market could also decline significantly in the coming years. In Tesla's 2020 Q4 conference call, then-CFO Zach Kirkhorn acknowledged that "regulatory credit sales will not be a material part of the business" over the long term.
Should this matter in deciding whether to buy Tesla stock?
When a real concern exists that a major contributor to profit will disappear in the not-too-distant future, investors should take notice. That's the case with Tesla.
But while there's a legitimate possibility that a big chunk of Tesla's profit could evaporate, this isn't the only factor to consider when deciding whether or not to buy the stock. A more important consideration is how much Tesla can grow profit despite the looming automotive regulatory credit issue. The company could have significant growth opportunities in the robotaxi and autonomous robot markets.
CEO Elon Musk said in the recent quarterly update that he believes that AI could help "make Tesla the most valuable company in the world by far." If his optimistic view comes anywhere close to becoming a reality, any concerns about the current $1.8 billion earnings distortion for Tesla stemming from automotive regulatory credits will also evaporate.
