In January, the Tesla board (with Elon Musk abstaining) voted to implement new CEO incentive and reward structure for Elon Musk. There have been numerous articles about what this could represent for Elon Musk, but not much is written about the consequences for Tesla.
There are some changes compared to the previous package, and when you change the goals, you will likely change the behavior.
The previous package was market capitalization and production oriented with an eye on gross margin.
The 10 operational milestones for the 2012 Performance Award are:
- Successful completion of the Model X Alpha Prototype;
- Successful completion of the Model X Beta Prototype;
- Completion of the first Model X Production Vehicle;
- Successful completion of the Model 3 Alpha Prototype;
- Successful completion of the Model 3 Beta Prototype;
- Completion of the first Model 3 Production Vehicle;
- Gross margin of 30% or more for four consecutive quarters;
- Aggregate vehicle production of 100,000 vehicles;
- Aggregate vehicle production of 200,000 vehicles; and
- Aggregate vehicle production of 300,000 vehicles.
And the market capitalization milestones were $4 billion each (so, $40 billion in total).
While there was an unattainable gross margin goal, there was no profitability goal. For a company in startup mode with a focus on growth, profitability is not a primary concern.
The new package is oriented towards a more mature company. Still no profitability but a focus on financial performance.
The new incentives are market capitalization with revenue and EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) as operational milestones.
The most consequential change is probably the focus shift from Gross Margin to EBITDA.
Gross margin is after depreciation and amortization but before R&D and SGA (Sales, General, and Administration).
EBITDA is after R&D and SGA but before depreciation and amortization.
When growing, developing, and investing, there is a grey area for many costs that are made for future products. They can be put on the balance and paid with amortization and depreciation or they can be taken directly on the Profit & Loss in R&D or SGA. For a young company in startup mode, it is considered best to take costs directly as a loss, because the chance of recovering them when the company fails is slim. A mature company in going-concern mode can put those costs on the balance sheet, trusting that they will be earned when the products and investment will generate revenue.
With the focus of Tesla management on gross margin, the incentive was to take development costs directly.
With the focus on EBITDA, activation on the balance of development costs becomes more attractive.
It is not a huge difference, without influence on the cash flow. Only a small portion of the costs are in this grey area, but it can make a real difference in the optics of the financial reporting, especially for profitability.
|Illustration of different PKI on accounting decisions|
|PKI Gross Margin||PKI EBITDA|
|cost of revenue|
|depreciation and amortization||200,000||250,000|
|sales, general, administration||200,000||150,000|
|sales, general, administration||50,000|
Looking at the milestones themselves, there is something else that catches the eye.
The EBITDA milestones look very doable. The $14 billion to cover depreciation and amortization can be generated by about $70 billion in plant and equipment on the balance sheet. And Tesla added just $4 billion in 2017 alone.
The revenue milestones are less easy to hit. It is about two thirds of the revenue of Toyota or Volkswagen AG. However, with a little inflation, 5 million cars per year, and some extra income from energy products and the Tesla network, these milestones are also within reach.
A quick look at the products that can earn the revenue:
- Cars at an average price of just over $40,000.
- Trucks costing about $180,000.
- Powerwalls costing about $1,000 (I expect the prices to drop with more competition and lower cell prices).
- Grid storage.
- Grid solar.
- Home solar.
- Supercharging network breaks even on profits and “pro-memory” on revenue.
- Megacharger network — a high-volume, low-profit profitable business.
- Tesla carsharing network — anybody’s guess is as good as mine. Ask Tony Seba for his opinion.
- Something new. Can anybody imagine Tesla/Musk not surprising us with a new line of products?
Tesla needs to sell only 4 million cars and 100,000 semi trucks in 10 years to surpass the highest revenue milestone.
When forecasters publish their growth scenarios, growth is seen as a fixed percentage per year, like large companies growing in all product sectors. Tesla will not grow in this way. It will grow in leaps and bounds, like it did when it replaced the Roadster by the Model S. Now this will happen again with the addition of the Model 3 to their portfolio. We can expect the same growth spurts with the introduction of the Model Y and the Tesla Pickup. The Semi will grow more slowly, not causing a sudden jump in scale, instead adding just a few billion dollars per year.
In energy storage, we can expect the same kind of growth spurts. That market is discovering the value of batteries for homeowners with solar energy installations and the value for utility operators to stabilize their grids. It is comparable with the car market when Tesla introduced the Roadster. The growth in the energy storage market has yet to really start.
Solar is a market that is able to have a normal growth pattern. It is already quite substantial and it has to scale in many markets.
Beside growth in its current markets, there is a possibility for growth in neighboring markets. The most obvious one is battery cells. Tesla is strong in vertical integration, like with its storage products, solar products, and power electronics to connect them; the same storage and electronics that are essential for their cars. It would be no surprise if Tesla acquired a battery cell maker like Panasonic or Northvolt.
Another market Tesla is not yet active in but could very well contribute its activities to is electricity transport. Adding HVDC interconnects to its portfolio would also be a possibility, as well as grid-scale solar plants.
However, an expansion into small electric airplanes is more likely. This is the venture JB Straubel approached Elon Musk about before they concluded that electric cars were more realistic. With better batteries combined with the Tesla expertise on power electronics and efficient electric motors, this is another transport sector they can disrupt; perhaps through the acquisition of a company with a great airframe.
The combination of acquisitions and Musk’s well known preference to have a large stake in Tesla make cash acquisitions more likely. Especially when the cash flow turns very positive. And the milestones will be adjusted for large acquisitions. Musk cannot reach a milestone by buying a large company.
The hard part is the market capitalization. Tesla would have to make either crazy profits or be expected to make crazy profits in the future. The only car company which did have a profit margin high enough was Porsche, but the volumes were too low to get into these stratospheric heights of market cap. However, market capitalization is only partly rational. The Musk factor, fast growth, and very cool products are ingredients of which the influence is hard to predict.