How did Tesla get into this hopeless situation?
What am I thinking? How can I call Tesla a very profitable company? Everybody knows better, right?
But I think Tesla is secretly a potentially very profitable company. Or not so secretly, if you really pay attention to Tesla’s finances. Let me explain.
To understand this, we have to make a distinction between profitable products and a profitable company. If a large conglomerate like General Electric would have a bad year — unlikely, but just for the sake of argument — everybody would still know that thousands of its products are highly profitable. I will go a step further — a conglomerate like GE will always have some bleeders among the tens of thousands of its products, whereas I think all of Tesla’s products become profitable after the development and ramp stage of their lifecycle.
The only reason Tesla keeps reporting losses is because after launching each successful product, the next product is so much more ambitious that it can’t be financed out of the revenue streams of the company’s current products.
To visualize this and make it easier to discuss, I have Tesla virtually split into separate companies, each providing a single product or service. Each company has its own financing, from sister companies or from the capital markets. Resources like design labs, research departments, specialized personnel, etc. are “sold” to sister companies for shares when no longer needed, mimicking the relationships between the parts of a consolidated company.
Take Tesla Charging Network Inc., for example. Originally, buyers of a Tesla car could buy a lifelong (the life of the car, not the owner) subscription to this network for $2,500 as an option. Then Tesla Model S Inc. included this $2,500 in the price of every car the company sold, making buying the subscription automatic with buying the car. Tesla Charging Network is financed by the subscription fees and contributions from the marketing departments of the car-making sister companies if those subscriptions don’t cover the expenses. Additionally, it can use money from the capital markets against future revenue from the Model 3 customers. The value of having the charging network to offer for Tesla’s car customers makes this a sound business plan for the hypothetical Tesla Charging Network Inc.
In the same way, all other parts of Tesla can be evaluated. Not all parts of Tesla are discussed below, just enough to make my point clear. Those parts of Tesla that are mature, are profitable. Those parts that are still young, and perhaps have some growing pains right now, will likely become profitable when grown up.
This picture below shows the main Tesla companies and the money-flows between them. The Tesla Charging Network Inc., Tesla Retail Shops Inc., Tesla Service Centers Inc., and many other even less significant parts of Tesla are left out of the picture for reasons of simplicity.
All these virtual companies go through 3 phases. First they develop their product, then they ramp production of their product, and finally they reach a steady “going concern” phase. When their product reaches End of Life (EOL), the company is liquidated. Only Tesla Roadster Inc. has reached that state.
In the Development stage, there is no revenue — all operating costs and capital investments (OPEX and CAPEX) have to come from outside sources. During the Ramp stage, the revenue starts to come in and the costs of R&D and investments in tools and equipment diminish. When entering the Production stage, there is a positive free cash-flow and profitability.
Tesla Roadster Inc.
Let’s examine Tesla Roadster Inc. in detail first, because this virtual company has gone through all the phases. It started in 2003 with the intention to launch an electric sports car. In the first 5 years, there was no product, no revenue, and hence the profit & loss sheet showed only a loss. All activities, and all expenditures, during these 5 years were targeted at creating a future revenue stream. That means that not only the capital expenditures, but also ALL operational expenditures were investments in future profits. The coffee machine, rent for office space, meetings with venture capital firms, raising money from prospective customers, and all the activities in the garage / workshop / design studio, as well as all the salaries were investments in future profits.
In a recent discussion about the axiom “a dollar in profit is a dollar not spent on growth,” someone made the suggestion that this was about CAPEX. Looking at the first 5 years of Tesla Roadster Inc., it is clear that it is not only CAPEX, but every penny spent to create a future product/service that can generate a revenue stream. This realization is very important in later analysis of Tesla financials.
In 2008, the first cars were produced and delivered. The first revenue came onto the books. But going from the first car to making cars like clockwork takes a while. The learning curve for Tesla was very steep. The ramp of the Roadster was an adventure for Tesla and the people in the company who were largely learning new professions in a new industry. Buying machinery and tools, improving their production technology, correcting mistakes in the car design — much had to be learnt and invested. During the ramp phase, R&D and CAPEX were first high but dwindled when the product and production became more mature.
After one to two years, the production phase was reached. There was not much if any need for R&D or CAPEX and there was a steady revenue stream. The owners of Tesla Roadster Inc., meanwhile, did start a second company, Tesla Model S Inc. That second company was the perfect investment for the profits of the Roadster. Besides the profits, the R&D team, the design studio, the goodwill, and all the IP that was gathered during the development of the Roadster were sold to the new Model S endeavor.
It was all paid for with shares, and when the Roadster reached end of life and Tesla Roadster Inc. was liquidated, all that was left was a bunch of shares in the next Tesla company. As is usual in the real world and this virtual world, after liquidation, the proceeds were distributed among the shareholders. They now owned a piece of Tesla Model S Inc. instead of Tesla Roadster Inc., and judging by their reaction, they thought the new shares more valuable than the old ones. Tesla Roadster Inc. was a profitable (virtual) company, but most of the beneficiaries of those profits were eager to invest them into a similar company with bigger plans.
Tesla Model S Inc.
Tesla Model S Inc. followed the same path as the Roadster company, with one difference. Besides the capital market, VC companies, and angel investors, they did receive large investments in money, resources, and manpower from sister company Tesla Roadster Inc. The contributions in kind were probably more important than the money, as they enabled a flying start for the development of the far more complex Model S.
While it took longer than expected to find a production location, once it was found, it took less time than anticipated to bring the Model S to production. The ramp was comparable to the Roadster ramp — lots of improvements of the car and the production processes, and after the worst of production hell was over, the involvement of R&D in the car and production process became smaller. CAPEX was very different. The production and assembly were designed for the ridiculously high number of 20,000 cars per year — no lack of optimism or ambition among the Tesla management. How wrong they were — CAPEX stayed high until the line was capable of over 50,000 cars per year, not 20,000.
The money, resources, and management attention this required ended up delaying the introduction of the next car, the Model X, produced by the virtual company Tesla Model X Inc.
The Model S was not only a huge success in terms of numbers sold in a growing number of markets, but it was also financially very successful, with a gross margin steadily above 25%. This is very good, but perhaps not as good as it sounds.
First, for every car sold, there is a lifetime subscription bought at Tesla Charging Network Inc. for problem-free road trips — that is $2,500 less gross margin. Further, while the Detroit Dwindling Three sell in bulk to dealer organizations ex-factory, Tesla has a direct sales model, using its virtual sister company Tesla Retail Shops Inc. The transport to the dealership (average about $1,000 in the USA) and the costs of sales (also a few thousand) have to be paid out of the lavish gross margin. What is left is probably still better than what the competition earns with its gas-guzzlers, but it is far lower than 25%.
Tesla Model X Inc.
With the Model X, it is becoming the same old dance and song. It got its first financing from Tesla Roadster Inc. and Tesla Model S Inc. It added office space, a better design studio, and experienced design engineers. For the production facilities, a little capital-market cash was needed. The prolonged design phase made some very advanced, but difficult to produce, features possible for the initial Model X that entered production. This is when we first learned of the Tesla-specific ramp process known as “Production Hell.” It also revealed the CEO’s favorite campground — sleeping on the floor along the assembly line. (This favorite campground would later be replaced by sleeping under the stars next to wild horses in Nevada, but that’s another story.)
But the wait was worth it in the end. The Model X cannibalized the Model S less than expected. It also generated the same or better margins. After a slow start, it climbed to the same impossible high sales its sibling had been seeing, with the expenses paid out of the gross margin essentially the same as with the Model S.
Tesla GigaF1 Inc.
The main problem with electric cars is the price of batteries. It appeared that a large part of the price was the costs of logistics — the stuff inside the battery cells traveled twice around the globe before reaching the carmaker. A cost reduction of 30% seemed possible when all production processes were concentrated in one, vertically integrated battery factory.
This became the Gigafactory in Sparks, Nevada. The giant factory is such a smart investment that many stock analysts have suggested dropping all other Tesla activities and just raking in the profits from this one.
Tesla Model 3 Inc.
The Model 3 is the victim of its own success. It received 5 to 10 times the number of reservations expected by the management. This number of reservations forced an acceleration of development and ramp from overly ambitious to stupidly impossible, according to many industry insiders. And as is often the case, more haste produced less speed. It also required a lot more capital expenditures up front, before the Model 3 sales could finance the ramp to full scale production.
Everybody can understand that the Model S’s 50,000 cars per year, and later supported by the Model X’s 50,000 cars per year, could not finance Tesla GigaF1 Inc. (aimed at over a million cars per year plus stand-alone energy storage systems) alongside Tesla Model 3 Inc. (intended to produce 500,000 cars per year). Billions were required from the capital markets for both Tesla GigaF1 Inc. and Tesla Model 3 Inc. Both have brilliant futures as moneymakers, but not in year one.
With low-cost batteries from Gigafactory 1, the Model 3 can still undercut the competition on price when the USA tax incentives are exhausted for Tesla, but the European laggards in the luxury-car segment still have them.
Tesla Retail Shops Inc.
The Tesla Retail Shops have a difficult history. Many American states forbid opening them, and in Europe you need many local organizations working in the local languages. Metropolitan areas with 5 to 10 million people have 1 or 0 shops. Making the assertion that Model S and Model X have saturated their markets is, let’s say, misinformed.
But a retail chain has to put cost before benefit, and there can be quite some time between opening the shops in a new country, and starting to get the sales volume that you need to finance them.
This is perhaps (one of) the biggest consumers of Capital Market Money between all the different Tesla companies, in the past and in the future. After a while, these shops become magnets for foot traffic and have the highest sales per square meter in the mall, the envy of many in the retail branch. Long-term profitability is not an issue. Upfront investment money and qualified personnel is what is holding this Tesla company back.
Tesla Charging Network Inc.
Just like the retail stores story, you have to spend money to make money. Originally funded by the $2,500 subscriptions of the Model S & X buyers, the new Model 3 customers have a limited subscription and have to pay for their energy. Again, the Model S & X subscriptions are not enough to build the network necessary for all traveling and the Model 3 customers.
Part of the cost can be claimed from the marketing budgets from the carmakers, and part has to be financed against the future revenues.
Tesla Service Centers Inc.
These will never be profitable. The intention is that most of the cost will be provided by the customers, but a part has to come from the carmakers. The electric vehicles are designed to require a minimum of maintenance, making the old business model of the retail car branch, with the service centers as the moneymakers, obsolete.
Tesla Energy Storage Systems Inc.
The future looked good before the Twitter promise about the Australian 100MW ESS/virtual power plant being operational in three months or it would be free. Now, after this demonstration of the value of ESS to grid operations, the future looks more than bright.
Tesla charging, retail, and the Model 3 are currently the big consumers of cash and creators of the quarterly losses. Charging and Retail expenditures are for a large part discretionary. The Model 3 expenditures are diminishing in the R&D and CAPEX departments and the revenue stream is expanding.
From here on, it is a management decision whether or not to start new projects — like Semi, Model Y, and Pickup — or open new markets — like Southeast Asia and Southern Europe — and create new cash shortages and losses for the consolidated company. An alternative is to take a breath and concentrate on having a profit and a large enough cash flow to grow without outside financing, to live within the company’s/companies’ means.
If, and that is still an IF, the Model 3 ramp will hit its second quarter targets before the end of the third quarter, it is out of the danger zone. The Tesla management thinks it can get out of the danger zone at the end of the second quarter.
To the immense frustration of many analysts and journalists, nobody outside the small management group at Tesla has the data to say they are right or they are wrong. My guess and hope is that they are right.