Published on May 10th, 2020 | by Alex Voigt0
7 Reasons Why Tesla Will Benefit From The Crisis — #6: Financials
May 10th, 2020 by Alex Voigt
The financial situation at Tesla has for years been called its biggest weakness. However, I will explain in this article why I believe financials are a strength for Tesla, and one out of 7 reasons why Tesla will benefit from the crisis.
Selling affordable vehicles in large volumes requires not only the creation of sufficient demand, but also a lot of capital to build enough production capacity to satisfy the demand with sufficient supply.
Capital is expensive if you need to borrow it from someone and thus pay interest, but without enough production capacity, you can’t produce and sell enough products to drive revenue to the scale needed to cover those costs.
To make money in a capital-intensive business like the automotive industry is hard, and is one of the reasons why about 50 auto startups since the 1950s didn’t succeed and went out of business. Since the covid crisis has hit all automakers and they all had to shut down production for a while, people make the conclusion that companies that don’t make money sustainably already will be hit most and go out of business first. That’s a fundamental misunderstanding of the automotive business and how financials work.
I am convinced that incumbent automakers will suffer more in the time of the crisis. Bankruptcies, mergers, and government bailouts should be expected. Tesla, on the other hand, will be in a much better financial position and prosper.
For many, financials are a “book with 7 seals,” a German phrase which means you don’t get through to the truth because it’s confusing, full of hard-to-understand Key Performance Indicators (KPI), and although full of numbers, not exact or reliable. Most people therefore tend to ignore financials, or use them without knowing the meaning and prefer to instead listen to analysts and others. It’s like asking a translator service while that translator earns money if you understand the text the way he wants you to understand it. That’s a mistake, and I recommend not doing that if you intend to invest in a company.
At the end of the day, for most, what the quarterly results mean boils down to whom you trust and believe the most. Belief is a bad strategy for investing.
We have seen interpretations of Tesla financials bending in all directions for years, the negative as well as the positive, so what is right and what is wrong? One way to get closer to the truth is to look at the past and evaluate how good or bad someone did consistently over time. If you do that, the facts and hard data prove that almost all analysts from large banks failed. Although, for many, each time you listened to them — because of their good reputation, large names, and fancy language — it sounded like what they said made sense. Don’t get fooled.
Below are three common issues with these analysts.
- Analysts who are responsible for automotive companies and are assigned Tesla [TSLA] have been analyzing a technology company (utility batteries, home batteries, solar roof, autonomous driving software, data collection, computer chip design and production, battery production) as a simple automotive company, going far outside of their field of experience. That’s not an assault on them, just a sad fact. For a decent analysis of Tesla, you need experts from at least 3 different fields (autonomous driving, battery technology, automotive) if not more (e.g., semiconductor, software-as-a-service), but banks are simply not organized to be able to provide such diverse know-how for one company.
- The earnings results presented from Tesla are compared from analysts against their own expectations, declaring a miss or beat of X% even though the analysts’ expectations have absolutely nothing to do with the performance of the company, only with their own missed or beat prediction from the past. In fact, most analysts have a really bad and low average track record for defining expectations in a realistic manner.
- The accounting principles used and regulated today are designed for companies to declare a GAAP profit as the #1 objective of a company, but there are other objectives that are eventually much more important for a growth company/startup, like sustainability, competitiveness, product pipeline, pace of innovation, and diversification. None of these are expressed as KPI, like EPS or cash flow. The focus of analysts on short-term profits has been proven wrong by companies like Amazon and Apple. Accounting rules used today do not represent a foundation for reporting the health of a company and its future.
Most of my readers know me as someone who does not provide financial assessments or analytics about Tesla, and since I define myself as not being a part of the daily news business, I have not done a single article or video about earnings releases, financial interpretation, or quarterly results, but I do assess and evaluate the financial situation from Tesla continuously.
My mission is to focus on the big picture, looking into technology, innovation, organization, and many other aspects of automotive and technology companies to conclude and predict how well a company is doing. However, I do financial assessment for myself and my patrons, as it’s a responsibility for me as an investor to understand details of the business that can be best seen on the balance sheet.
In this article and the respective video, I will try to address the financial situation of Tesla in comparison to other automakers in the time of the ongoing crisis for those who don’t want to dive deep into financial numbers, KPI, and all their complexity. The majority of people who like to understand how well or badly Tesla is doing are not experts in financials but still deserve a balanced and fair assessment without relying on analysts who, as outlined above, are not a good source for understanding Tesla and its financials.
The world of finance is an expert language for people who don’t agree on its meaning between themselves. It’s used everywhere by people who invest, but translation into a commonly used language differs very much depending on who you ask.
The majority of people either hate financials, balance sheets, and key performance indicators or are confused by them, not knowing how they are defined and calculated and what they mean, which creates uncertainty and doubt. This article will not use those terms as known terminology but explain some aspects as if all those metrics/definitions did not exist. I believe there should be a world where the performance of a company can be described without complex expressions for an average person from the street who has never heard of them.
The first mistake in finance and its accounting starts with the claim that a balance sheet reflects all the movements of a company — be they financial, physical, or service. The truth is, a balance sheet reflects what has been defined as having a dollar value, determined by a small group of smart economic scientists about 100+ years ago — and therefore no longer on balance with reality, if it ever was. Today, these are called “Accounting Principles.”
Many accountants claim they can read a balance sheet like a book and know all about the company by reading and comparing numbers. That would indicate a balance sheet tells you something about:
#6 Employees & Management
#10 Brand value
… to name just a few things, and we all know it does not tell you about those things at all.
A balance sheet and quarterly report are helpful if you speak and read that language, but they can be harmful if you don’t and can be dangerous for your investment if you can’t put it all into context.
In Germany, about 99.5% of all companies are the so called “Mittelstand,” or smaller companies, “small and medium-sized” companies usually founded and owned by families over generations that generally make sustainable and substantial revenue and profits in the billions of euros. 60% of all employees that pay into the social security systems in Germany are working for the Mittelstand. These companies are often quite large, not really a “medium size,” but they are not the public listed giants — like Siemens, Volkswagen, and SAP — that everybody thinks about when talking about Germany’s economy. Privately owned, they do not have to play according to the accounting rules noted above, GAAP or otherwise. These companies are not known by name in most other countries, even if you use products daily that wouldn’t be feasible to produce without them. To be a publicly traded company may be tempting for them, but they have good reasons for deciding with conviction against that option.
The Mittelstand is the true backbone of the strong German economy and has proven over generations that it can survive a crisis very successfully even though (or because) they don’t play by the rules of Wall Street, showing quarterly profits and paying high dividends at certain points in time to please management and shareholders. Sometimes it is wiser for the sustainable success of the company to accept losses for a few quarters or even years.
Around the corner from the place where I am writing this article is a successful family-owned company that has had profits for 13 generations, now being 390 years old. It has they never created a balance sheet like the ones we know from publicly traded companies. It is doing very well in this crisis as in all the others it has experienced in the last 4 centuries.
So, why have all of these accounting rules at all? They’ve been invented as a way of creating clarity for people who give you money to run your business. Unfortunately, that invention has failed miserably at its task. It’s the best we have, but not good enough.
Company financials are described by accountants using the four most basic calculation methods — subtraction, addition, multiplication, and division. If you use basic math, you just get basic answers. The language used is extremely simplified, so by definition you get simplified answers. The answers may be accurate, but they don’t describe very well what you are trying to describe. It’s like using a language with 1,000 words and wondering why you cannot express yourself like you could if you used a language with 10,000–15,000 expressions. People believe the Inuit have the most words for snow, but it’s actually the Scots, with 421 words for conditions of snow (according to a study from the University of Glasgow) — but both have a lot of words for snow, and they have them because they use and need them.
Beside the successful German Mittelstand, there are many companies in the world who for good reason would love to abandon these accounting principles and restrictions. The CEO of Tesla, Elon Musk, is one of them. In some of Elon Musk’s tweets and interviews, he made clear that the quarterly financial accounting does a lot of harm and less good. His expressed thought to take Tesla private was, among many reasons, driven by the hassle to have to play by the rules the Wall Street banks dictate.
Taking all of that into consideration, I would like to highlight for everybody who does not to like to talk about financials a few financial indicators by relating them to our normal lives. To be able to do that, I will use basic analogies everybody is familiar with from his or her day to daily life. They are not 100% perfect.
First of all, in the world of finance, two comparisons need to be considered — one is development over time, and the other is comparison to peers.
Let’s do this with just a few indicators, starting with a very simple one that is not really a financial indicator but an expression of the headline of my series — why Tesla will benefit in the crisis, market share.
You benefit when you grow your market share, which is for Tesla one of the most important numbers to look at, because the mission of the company is to accelerate the adoption of sustainable transportation. Accelerating that mission is only possible if other automakers are forced to bring better and more fully electric vehicles (BEVs) to the market. and they will only do that once they painfully lose market share to competition like Tesla.
The graph below shows you the BEV market share of all automakers together compared to Tesla. In Germany, in April, Tesla grew 10% while all other automakers lost market share. That is in a country that claims to have invented the automobile, with iconic traditional companies like Daimler, BMW, VW, Audi, and Porsche.
#Tesla: This is what truly disruptive innovation looks like! Oh, and TSLA’s balance sheet looks like a fortress compared to those of many other auto manufacturers. What a difference a year makes! https://t.co/miWZuA6i15
— Cathie Wood (@CathieDWood) May 3, 2020
An analogy: if you are a salesman selling refrigerators in a defined region and all households just buy from you, you have 100% market share. Tesla is the new kid on the block that just started selling to households you sold to for over a century, and now 30% or more are buying from Tesla in the matter of just a few years, while your market share is shrinking.
Another example of how to look at this is to compare Model 3 market share in the US to all sedans from Audi, BMW, Jaguar, Daimler, Lexus, and Porsche in the same segment. Since the Model 3 has been on the market a while, an outlook into the future is the Model Y compared to its peers and competitors, with the illustrated market share it’s attacking. While no one knows right now if the Model Y will do as well as the Model 3 did, taking more market share than all other vehicles in the class combined, the true question is, why should it not?!
The market share for BEVs has been growing in the crisis, and with Tesla a 100% BEV producer, the company will benefit from it the most considering its leading technology. Tesla’s global share in BEVs grew from 17% to 22% before the crisis, and there is no stop in sight despite comparably higher sales prices per vehicle. In other words, Tesla is selling more units of vehicles that make on average more revenue per car than the competition.
The second key performance indicator I would like to look at is a little bit more complex but gives you a strong understanding of the financial health of Tesla in one number. It puts income and debt into relation.
Although the graph headline looks complicated, it really isn’t. Allow me to explain its components first by comparing it to a normal household.
Debt is all that you borrowed and sooner or later have to pay back. In order to get net debt, you just deduct all cash you have on hand from it. In other words, it’s the debt that is left if you scratch all available coins together that you can find in your house and after you’ve sold your watch to your neighbor. Net debt is everything you really can’t pay back quickly. No one wants to have high net debt.
EBITA is earnings before interest, taxes, and amortization. Sounds complicated, but it isn’t. Allow me to explain.
Imagine you are an employee, you get a salary, and EBITA is your salary before you pay:
- Income taxes and social security fees, including insurance
- Interest for your car loan that is required to commute to work and all other expenses you had to cover to do your job.
- The lost value of your car because it gets older and you only can sell it for less, which you can call amortization.
In simple words, EBITA is nothing other than your gross salary before you pay for important commitments that you had to make in order to be able to do your job as well as your commitments as a citizen of the country you are living in. It’s what you have earned but it is not at all what you have left for yourself and your family to consume or spend, which will be less. It is what you tell your neighbor you earn, knowing that in fact, given all commitments you have, the situation looks worse.
Adjusted EBITA means nothing else than that the calculation is standardized to eliminate anomalies that would make your “Gross Salary” otherwise not comparable to that of you neighbor.
Let’s try to understand now what that key performance indicator’s meaning is. If you divide the hard debt, the one you really can’t pay back, with the cash you have in your wallet, through your gross salary you actually know how deep or less deep you are in debt.
If the number is below 1, you have more gross salary than debt in your bank account, which is a positive. If it’s above 1, it shows you that even if you took your salary without pending deductions, it won’t be enough to pay your debt back if they asked you today.
TTM in the chart header means “trailing 12 months,” which is nothing other than you taking the average of the last 12 months of the ratio of your debt versus your gross salary, which shows you more clearly if you have a constant trend or just an outlier quarter.
If you watch that number over time for every quarter, you get a really solid indication of whether you are moving into a situation where you will be very quickly able to pay off all debt if requested or not.
Let’s have a look at the chart above. For Tesla, over the course of 2 years, or 8 quarters, the situation improved over time from a moment when almost 7 times “your gross salary” was not enough to pay off your debt, to today when you are able to pay it off with just 1 “salary,” and you’d have money left over.
That’s Tesla today, and this improvement comes despite the fact that the corona crisis hit in Q1. This is a strong success, and the trend over the quarters shows that it’s a stable, continuous improvement you can assume to continue.
In every quarter that passed by, as a household, you were able to generate more income flexibility for you and your family despite expanding your house(s), cars, and business with a better computer and more employees which will give you even more income in the future using these assets. If you compare that to other automakers and how they developed in the last 2 years, you can understand why they are jealous and why you don’t hear them talking about Tesla’s financials any more.
Last but not least, I would like to explain what gross margin is and why it matters. Gross margin is the profit you make in percent of the revenue you collect.
An analogy: if you sell your house but you have to do some aesthetic repairs up front (e.g. garden work and cleaning), in short, you have some costs associated and also have to pay a professional real estate agent with a commission to sell it for you. The total costs reduce your net cash, or what the agent gives you after the deal.
This profit that is left for you, as a percentage of the sale price the agent achieved from the new owner, is the gross margin. It does express how much you had to spend to make the deal and get the house sold. That spend is called COGS, or the cost of goods sold, which is another indicator.
The gross margin tells you how much effort you had to exert to make the deal, and it gives you an indication of how much return you get from your business and thus your profitability. A high gross margin is not only nice for your business and shareholders, but it gives you more flexibility and freedom to invest further in your business and to weather a crisis (like the one we are in) successfully. It tells you something about your efficiency and how badly customers want your fridges.
Tesla in the middle of the crisis has achieved an automotive gross margin of 25.5%, which is a market-leading number and much higher compared to other automakers, even if you look at the still healthy auto sales year 2018, as you can see from attached graph.
Now let’s assume our salesman has another house he is renting out and creates incremental income and cash with bonds or stock dividends as well. That’s great to have, but if you want to understand the health of the fridge business, you just look at how much money is left in your pocket after the fridges have been sold and the customer paid. That cash in your pocket is called operating cash flow, and it’s looked at disregarding any other potential cash generation you might have.
Operating cash flow highlights whether you create money you can spend after costs are deducted. If it is negative and you even have to borrow money to sell your fridges, it shows you that you do not have a sustainable business model in the long term.
Since one month or quarter number may be an outlier, you get a clearer picture by looking at a trailing 12 month view.
If we now look at the 12 month trailing operating cash flow chart from Tesla, we do see that the business creates cash sustainably, illustrated with the blue bars. Even more positive, it trends higher from negative to the positive in the last 3 years. That indicates that you do something right with your business model and that you have the costs under control.
If you generate a lot of cash out of your fridge business, you may want to hire more people and expand. Therefore, that number will stay positive but not grow through the roof if you have an expanding market because you are investing in the future. That’s exactly the situation Tesla is in. Therefore, a trailing positive cash flow is great and gives Tesla the opportunity to finance further expansion, like Giga Berlin, Giga Shanghai, and the factory Elon Musk mentioned will likely to be built in Texas — out of Tesla’s own pocket, without asking any banks or investors for money they have to pay interest on.
If you deduct that investment for further expansion from your operating cash flow, you get free cash flow, which is, if you will, a more conservative view on what is left in your pocket after expansion costs.
For our Fridge, Inc. entrepreneur, this means he builds, for instance, a new fridge assembly line and all of that investment is deducted from his operating cash flow. If, after all that big investment, still have cash in your pocket, you know you will in the future make more revenue and cash than even now. Looking at the red bars in the chart, you can see that Tesla makes money despite expanding and investing heavily in gigafactories. And that trend is stable and positive, too.
Let’s Summarize & Conclude
Tesla is, to compare it to our salesman business that we used as a metaphor, selling more fridges than any other company in your region despite the fact that the others are 100 years old. You, the salesman, increasingly dominate the market and your customers love your products.
You have very low debt considering your income. You sell your fridges with very low associated costs, like transportation and installatons, and therefore what you get out as a profit is higher and trending increasingly higher compared to competitors. No one makes more money with every sold fridge.
Since you decided to build your own fridge assembly line, which requires a lot of upfront investment without having a single additional fridge from that line to sell yet, your wife expected no cash to be left for other expenditures, but in fact you still have cash in your pocket. Once the line is finished, and since you know the market is asking for your fridges in other regions too, you will create even more income, and with it more cash.
Tesla is financially in a better position right now than any other automaker if we just look at the automotive business unit and forward looking increases in investments for a profitable business model. It should be able to accelerate its global expansion, profits, and cash.
That’s an extremely positive and unique situation to be in, and Tesla’s financials are therefore one out of the 7 reasons Tesla will benefit from the crisis and prosper in the future.
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