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Less Than Meets The Eye (NASDAQ:TSLA) –

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Tesla Service Center. Tesla designs and manufactures the Model S electric sedan IV

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It’s been a long time since I have written anything for Seeking Alpha about Tesla (NASDAQ:TSLA) as I have adopted the attitude of many Tesla bears, which is nicely summed up in this quote from Jonathan Swift:

“You cannot reason a person out of a position that he did not reason himself into in the first place.”

As Montana Skeptic is fond of saying, investing in Tesla owes more to theology than finance. It’s a religion. Logic and analysis are irrelevant.

However, a recent trend in bullish Tesla articles has obliged me to break my silence. This is the belief that Tesla is a free-cash flow (“FCF”) beast and that this justifies its enormously elevated stock price. The first time I noticed this argument was in this article from October 2021, but it has since been followed by this article, this article, this very recent one and then this one as I was working on this response. These articles make similar arguments that Tesla’s reported FCF (or a derivative of it, such as its FCF margin) can be projected into the future for valuation purposes.

But the problem is, if this starting FCF number is not sustainable or otherwise invalid, then the entire analysis is flawed. And the starting FCF number is demonstrably invalid/unsustainable for at least 4 reasons.

Before I go into these reasons, I want to make my argument perfectly clear: I am NOT arguing that Tesla’s reported historical FCF is incorrect. What I am arguing is that valuation is always a forward-looking exercise and therefore the question is whether Tesla’s current FCF is a reliable basis for projecting future results. And it clearly is not.

The Reported Numbers

Let’s focus on Tesla’s 2021 results since these are the last audited figures we have and since I am too lazy to aggregate TTM results from quarterly statements; the basics of the story are unaffected by this choice. For this year, Tesla reported cash flows from operating activities of $11.497bn. Tesla also reported investing activities of $6,508bn (after eliminating the effects of Tesla’s purchase and sale of Bitcoin and marketable securities, which (despite its accounting treatment) is cash management and not investing[1]).

So, the net result is FCF from operations of $4.989bn, which means that not only is Tesla fast growing but it is also a cash-generating machine. What could be better, right?

Wrong.

Problems with the Reported Numbers

Problem Number 1: Stock-Based Compensation (“SBC”)

Tesla reported, as operating FCF, the add-back of $2.121bn of SBC. Most of the authors cited above (although, to his unique credit, not Alaric Pow in the latest article, who included an explicit dilution number in his analysis) have treated this as FCF that has no cost to Tesla or its shareholders, neither as a transfer of value to employees nor in creating dilution.

I have no desire to enter into a lengthy debate about the morality, recruiting necessity or accounting treatment of SBC. I hope that we can all agree that it is either a true cost to the company or you have to explicitly take into consideration the impact of its dilution on the stock value. You can do one or the other, but you can’t ignore both, which is what nearly all of these authors do.

I think that the economically logical way of looking at SBC is that it is a cash cost which is simultaneously financed by the targeted issue of shares to the employee beneficiaries. In other words, it is cash from a financing and not from operations.[2]

With this adjustment, operating FCF is down to $2.868bn.

Problem Number 2: EV Credit Sales

EV credit sales are, of course, FCF. I am not disputing that. But, for valuation purposes, are they the type of sustainable FCF that can reasonably be projected into the future, which is what all of these authors do? Although this isn’t as clear-cut as the mistreatment of SBC, my answer is: no.

As with SBC, I have no interest in entering into a debate on the morality, public policy wisdom or longevity of the government programs that give rise to these sales. Been there, done that, have no interest in repeating. But I will simply point out that almost every major automobile company – Ford, GM, VAG, Mercedes Benz, BMW, Fiat Chrysler Peugeot, Hyundai/Kia, Honda, Toyota, etc. – now has a well-established EV production program. This is why, for example, Fiat Chrysler has announced that it is terminating its EV credit “pooling” arrangement with Tesla in Europe, which has been one of the largest sources of EV credit sales for Tesla. Another big buyer, Honda, has announced a large EV program, targeting 30 models by 2030, which will likely also eliminate the need for it to be an EV credit customer.

Tesla will continue to produce net EV credits – assuming that governments maintain these foolish programs, which isn’t a given – but it isn’t obvious who will need to buy them and, given the law of supply and demand, it is even less obvious whether the price at which Tesla is selling them will be maintained. At least not on the long-term basis that all of these authors assume in their valuations.

(If the Tesla bulls disagree with this statement, then they should take up the point with Tesla’s CFO, Zach Kirkhorn. He famously said, in a quarterly earnings call, that sales of EV credits “in the long-term will not be a material part of our business.”)

The impact for 2021 is $1.465bn (assuming that these credit sales require no cash costs, which is likely true).

So, sustainable, long-term FCF is now down to $1.403bn.

Problem Number 3: Income Taxes

For 2021, Tesla reported income taxes of $699mn on pre-tax profits of $6.343bn. Seems kind of low, doesn’t it? A tax rate of 11%?

If you read Tesla’s tax disclosures[3], you will see that Tesla benefits from a number of short-term tax breaks. For example, the operations in China – which account for more than all of Tesla’s pre-tax profits, as indicated in Footnote 14 of Tesla’s Form 10-K (as pointed out by Gordon Johnson) – have been granted a reduction in income taxes from the statutory rate of 25% to 15%. But this reduction expires in 2023. It goes without saying that this temporarily inflates Tesla’s FCF[4] and is not sustainable over the long term. Likewise, Tesla’s US tax liabilities may be temporary reduced by the company’s huge historical operating losses, which can be carried forward against future earnings. This is also a temporary benefit – or at least it is if the profitability dreams of the Tesla bulls are realized.

How much should we adjust Tesla’s 2021 results to come up with a better estimate of sustainable FCF for valuation purposes? Tough to say, but the number certainly isn’t zero.

Even though a strong case can be made that the tax rate should rise by 10%, since this is the increase in China and China probably accounts for all of Tesla’s profits, let’s be more conservative and cut this in half to 5%. This will mean an increase in Tesla’s tax bill of $317mn and an equivalent reduction in its FCF. (Note that, in addition to being conservative on the possible impact from China, this assumption also ignores any future tax increases coming from Tesla using up its loss carryforwards or the expiration of other tax benefits (like in Nevada).)

So, sustainable, long-term FCF is now down to $1.086bn.

Problem Number 4: R&D and Servicing

At this point, Tesla is basically a 2-car company – or really a 1.5-car company if you consider that the Model Y is just a bloated derivative of the Model 3. Sales of these two cars account for over 97% of Tesla’s total unit deliveries in 2021.

Tesla’s other two models (the Model S and Model X) are now, respectively, 10 years old and almost 7 years old without major revamps (although the former has received a yoke steering wheel, so there is that). Their combined sales were down by over 56% in 2021 versus 2020. These two models should have been packed off for an honorable (in the case of the Model S) and very dishonorable (in the case of the disastrously engineered Model X) retirement long ago.

Tesla’s “pipeline” consists of phantasms such as the Cybertruck (introduced in November 2019 and now promised for 2023 – although this promise is made on “Elon time” and the price and specifications are anyone’s guess), the Semi and the Roadster (both introduced at the same festival of vaporware in December 2017), and the $25,000 model that was first teased as a fluffy pillow in September 2020 (and which has since been seen nowhere except in the imaginings of the Tesla bulls). In addition to these vehicles allegedly under development, Tesla is perfecting its solar roof, developing its own high-performance batteries, making industry-leading advancements in manufacturing processes and even developing a robot – although currently it only has a dancer in a spandex onesy! Those Tesla R&D folk must certainly be working overtime and there has to be lots of them. That must cost a lot of money.

Apparently not. Over the last three fiscal years, Tesla’s R&D as a percentage of revenue has equaled 4.9%. On the same basis, GM has been 5.4% and Ford has been 5.3% – even though GM and Ford have each had revenues roughly four times Tesla’s during this period and one would expect significant economies of scale in this area. Tesla appears to be more R&D intensive compared to some of its international competitors (Mercedes at 3.8% and Toyota at 3.4%, but not nearly at the level of VW at 6.0%) but these figures might be skewed by very different accounting practices.

I can’t prove it mathematically but it appears pretty obvious that Tesla’s R&D effort has been pared to the bone[5], which probably accounts for its aged fleet and its vaporish new product line. So, what if a more realistic number for Tesla would be to spend 6% of its revenues on R&D in 2021 instead of the 4.8% that it actually spent? This would be a $638mn hit to Tesla’s FCF, reducing it to $448mn.

But this isn’t all. Servicing is also another area where Tesla is likely underspending. Here is a table from an analyst in a hedge fund who tweets under the name of Motörhead (@BradMunchen).

Tesla cars on the road versus service centers

Analysis from Motorhead (@bradmunchen) (@brad

(The title of the table is somewhat misleading because it is actually vehicles per service centers and showrooms, the latter of which cannot perform services. Tesla does not disclose service centers independently. The absolute numbers may be misleading but the trend is almost certainly accurate.)

If these results look sustainable to you, perhaps you should dip into some of the servicing comments in the Tesla Motor Club to read about the struggles with long wait times for servicing appointments and/or spare parts. Or take a look at some of the Twitter hashtags catalogued by Scot (@ghost_scot) (#TeslaServiceIssues, #TeslaWarrantyIssues, #TeslaLoanerIssues, #TeslaRefundIssues, #WhereAreTheParts) which attest to the same problems.

I won’t even attempt to put a number on this, although Motörhead estimates that restoring the level of service to Q1 2018 levels would require $18bn of capex and a lot more operating expenses. It is easy enough to see that a more realistic servicing effort would put another significant dent in Tesla’s sustainable FCF and probably drive it negative.

Other Stuff and Conclusion

The above comments are deliberately simplistic. The point of them is, in part, to encourage readers to ask themselves: “If these are the types of pretty obvious points that have to be ignored to have a bullish view on Tesla stock, then what does this say about Tesla’s valuation?”

But there are deeper issues, too. For example, Tesla runs a leasing business for its cars and solar energy systems. This leasing business has a significant impact on things like investment and depreciation, and therefore reported FCF. This is a financing business that is radically different from the production and sale of cars. Should these cash flows be lumped in with the rest when projecting future results or should they, as is customary with a sum-of-the-parts valuation of other automotive companies, be treated separated?

Likewise, Tesla reports significant and fast-growing obligations under operating leases. Operating leases are a hidden form of CAPEX. What would happen to Tesla’s FCF numbers if an adjustment were made to treat these obligations as CAPEX?

But these types of subtle adjustments don’t even have to be made. The glaring problems with Tesla’s reported FCF numbers, which render them useless for projecting its future long-term performance and for valuing the shares, are hiding in plain sight.

Warning

Tesla is the original meme/bubble stock. Its trading levels have been divorced from reality for a long time and continue to be so, although at a greatly reduced level with the stock currently over 40% off its all-time high. Other meme/bubble stocks are more than 90% off their ATHs and I expect Tesla ultimately to join them. However, as the recent demise of Melvin Capital shows, shorting meme/bubble stocks is a risky business and I cannot advise anyone to do it. Better to sit on the sidelines, sleep well and enjoy the schadenfreude.


[1] The authors have not even made an adjustment to eliminate these “investments” from Tesla’s FCF, even though it strengthens their bullish arguments.

[2] Please spare me comments like “this is not GAAP!” If the accountants got everything right, economically speaking, then there would be no need for financial analysis, right?

[3] Described in the lengthy section entitled “Programs and Incentives” in Tesla’s 10-K. This section makes funny reading for those who believe Elon Musk when he says that he doesn’t want incentives.

[4] Although one author does not make this mistake, since he totally disregards the impact of taxes in his valuation model. Apparently the need to use cash to pay taxes has no effect on valuation.

[5] Some Tesla bulls try to deflect from this fact by pointing out the amount of R&D that Tesla spends per car that it sells. By this metric, Lordstown Motors must be a technological giant since its R&D is infinite when divided by the zero vehicles it has sold.



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