One of the common criticisms of electric-car maker Tesla Motors (TSLA 2.90%) is that it isn't making any money. After all, how can a company that is actually reporting net losses be worth $30 billion? Its mind-boggling rate of cash burn is frequently cited as proof of a poor business model. But there's more to the story.
Not only is Tesla actually proving that its business is, indeed, scalable, but it's also arguable that investors shouldn't want the company to be reporting profits at this point in the game.
Tesla factory in Fremont, California. Image source: Tesla Motors.
Understanding Tesla's spending
While Tesla's vehicle unit sales are growing at about 50% year over year, the company's bottom line is going nowhere. In the electric-car maker's most recent quarter, Tesla reported a $184 million loss, greater than the $62 million loss in the year-ago quarter.
There are several areas that have significant negative effects on the company's reported net income -- all of which are easy to understand. These items are filed in operating expenses under research and development, and selling, general, and administrative categories.
Between Tesla's second quarter of 2014 and its year-ago, research and development expenses increased to $181.7 million, up 69% from $107.7 million in the year-ago quarter. This growth in R&D spending easily exceeds Tesla's 24.1% increase in revenue during this period.
Similarly, SG&A expenses are up 51% from the year-ago quarter, reaching $202 million in Q2.
Between Q2 2014 and Q2 2015, Tesla's R&D and SG&A expenses rose from representing 27% of revenue to 40% of revenue. This increase is the primary reason for the company's inability to improve profitability during this period. Is this proof that Tesla's business is lacking scale? No, not at all.
The incremental operating expenses as a percentage of revenue are not due to declining efficiency and worsening scale in selling the company's Model S. Indeed, the relative increase in Tesla's operating expenses is primarily aimed at a range of future projects aimed at doubling Tesla's revenue in the next few years. Driving these costs higher, Tesla cites development validation and testing of Model X, early-stage development of Model 3, and expansion of the company's sales capability. Tesla is hoping Model X will double the company's vehicle sales volume, and it's betting that a launch of its lower-cost Model 3 by late 2017 will help it take a step closer toward a vehicle sales volume of 500,000 per year by 2020. Furthermore, while Tesla's increase in operating expenses related to expanding its sales capability is certainly a driving factor of its growth in Model S sales, it's also setting a foundation for a larger retail footprint for Model X when it launches.
Model X prototype. Image source: Tesla Motors.
Zooming in a bit closer at Tesla's more recent progress in operating efficiency, it's more evident than ever that the company's business is maturing. Sequentially, Tesla is actually improving its operating efficiency, even as growth initiatives drive operating costs higher. Consider this excerpt from the company's second-quarter letter to shareholders:
We improved our operational efficiency for the second quarter in a row, achieving record deliveries and developing new products while managing to grow operating expenses at a slower rate than the growth in our non-GAAP revenue. Our operating expenses in Q2 were $345 million on a non-GAAP basis, up 6.5% from Q1.
Non-GAAP revenue during this this period increased 8.5% between Q1 and Q2.
As a side note, Tesla's non-GAAP revenue metric is a safe figure to use since it is more closely aligned to the actual revenue related to vehicle sales than its GAAP revenue. Non-GAAP revenue adds back deferred revenue for cars sold with Tesla's resale value guarantee.
What about Tesla's cash?
Turning to the cash flow statement, Tesla's rising capital expenditures may spook some investors. The company's trailing-six-month capex spending reported in Q2 increased from $317 million in the year-ago period to a staggering $831 million. As startling as this increase in capex spending seems, understanding exactly what's behind the increase helps to reduce any anxiety.
For the full year, Tesla expects to spend about $1.5 billion on capital expenditures. However, all of this spending is directly related to Tesla's long-term growth, the company stated in its second-quarter 10-Q filing. As factors that are driving growth in capex spending, Tesla cites efforts to expand its production capacity, complete Model X development, continue to build its Gigafactory, grow its retail and service footprint, build more Supercharger locations, and "continue other product development programs, including Model 3."
Rendering of a complete version of Tesla's currently under-construction Gigafactory. Image source: Tesla Motors.
Do shareholders want profits today?
While reviewing these reasons for Tesla's inability to report profits or free cash flow, it's worth considering whether Tesla shareholders would want the company to be consistently profitable at this point.
Musk & Co. have proven to investors that there is sufficient demand for fully electric vehicles. Vehicle sales are expanding as fast as Tesla can ramp up production, and it already has over 20,000 reservations for its Model X. Incredibly, Tesla has achieved all this without spending a penny on advertising.
If Tesla shareholders were surveyed, chances are that many of them would prefer Tesla to continue spending heavily on Model X and Model 3 development, Gigafactory construction, sales and service capability, and more Superchargers. Each mentioned initiative is crucial to the company's growth story and management hasn't given investors any reason to believe that its rising operating expenses and increasing capital expenditures won't provide a handsome return on investment for shareholders.
Sure, traders with a short-term time horizon will likely disagree. Regardless of this, buy-and-hold Tesla investors most likely prefer to forgo profits today for more growth tomorrow and bigger profits in the future.
