Tesla’s stock is up 208% year-to-date.
Donn Vickrey at Gradient Analytics agrees that Elon Musk and his team have created a good product.
But he isn’t buying the recent hype.
“Thus far, the company’s results have been driven by nonrecurring boosts and accounting gimmicks, all of which are either unsustainable or purely cosmetic,” he wrote in a note earlier this month. He gave the company’s earnings an F.
Vickrey’s main concerns are 1. The recent demand has reflected pent up demand, and it’s unclear if this is sustainable. 2. A 25% gross margin by the end of the year is unlikely considering the company’s low volumes. 3. Tesla has limited room to absorb warranty costs. 4. The car is expensive and affordable only to the one-percenters.
Here is an excerpt from our interview with Vickery:
Business Insider: A lot of people have truned bullish on Tesla. What are they missing?
Don Vickrey: There’s been a lot of irrational exuberance about an unproven technology. What’s unproven about it is both on the revenue side – unproven is the level of true demand for the cars. In the most recent quarter they outsold all other comparable luxury cars, comparable in terms of price, and the demand for luxury cars is something that is fairly stable across time. It may go up or down slightly depending on the economy and such, but the spike in demand that we saw recently was what we called pent up demand.
…Then my expectation is that the demand doesn’t stay at the same level; it’s primarily a function of price. It’s a very expensive car. They don’t really have anything comparable to a Nissan Leaf or a Toyota Prius that they can sell to more average, middle class customers. Right now we’re seeing sales of pent-up demand for a niche product, a very expensive car that appeals to a specific type of customer who views themselves as being either cutting edge or green one of the above. I seriously doubt the demand will continue. That’s kind of the top line.
BI: What about costs?
DV: On the cost side, people are willing to ignore that as long as the demand appears to be there. Costs of their businesses are also extremely problematic. If you take out the zero emission vehicles (ZEV) credits they’ve never made a profit, and in the most recent quarter they got $68 million from these credits. You back that out and they’ve got a massive loss again. They’ve already said they have to wean themselves off these credits and that their ability to sell them is going to diminish relatively quickly. At least what they’re saying is that they don’t expect much of any by the end of the year. That they believe they can make a 25% gross margin just doesn’t add up. …Their ability to stick to that number, at such low volumes, is very unlikely.
BI: And the rate of warranty accruals?
DV: I don’t believe that they’re doing sufficient warranties right now. And right now their warranty accrual is about the same as Ford or GM. What’s problematic about it is it’s very new technology. Ford and GM by and large are selling at very established platforms and very established technologies the incremental change from one year to the next in terms of technology is not that large. Whereas Tesla really has no idea. There’s a point in time, it’s 10 years if I’m right where they’ve guaranteed the owners a battery replacement, but they have accrued nowhere near enough to replace batteries, for those that need batteries. Not even remotely close. They have a similar problem going forward on the Model S. They haven’t guaranteed a replacement but they are if after eight years or 125,000 miles it remains to be seen, …the cost of those things is exorbitant. …It would be like Ford or GM saying we’re going to guarantee you a new engine at the end of a period of time. That would be very expensive. That causes your warranty costs to go up significantly.
…Plus you’ve got a completely new car. When you introduce a new car even Ford or GM has to have a higher expected warranty expense for brand new platforms, brand new cars, because the first model of a car has far more defects than say later on down the line when they become more efficient, more effective, quality-controlled. Yet none of that is reflected in the financials. The bottom-line without the ZEV credits and what I think would be a more reasonable accrual they basically have no gross margin.
BI: How much of the accounting gimmickry is a function of the company trying to hide losses versus just being a very young company taking advantage of accounting tricks?
DV: I don’t think there is any relationship between the age of a company and the use of lenient accounting. According to accounting research, the primary motives for earnings management are management pay/tenure (which is often a function of earnings and/or share price) and the need for capital (either to meet existing debt covenants or raise additional debt or equity capital). Another factor may also be poor internal controls.
BI: Do you think Tesla’s going to fail?
DV: I wouldn’t want to speculate on whether or not Tesla is going to fail. Elon Musk and his team are very talented and they have produced what appears to be very good product from what I can tell. That said, the cost is exorbitant and affordable by only the one-percenters of the world. I don’t see how you can stay in business selling electric cars to one-percenters. So ultimately the question will be, can they build a car that is affordable to the average buyer before they run out of capital? Will the market continue to value shares high enough to fund the next capital raise? And the one after that? Until that question is answered, I think shares are terribly overvalued. Call it irrational exuberance, much like we saw during the internet and telecom booms.
BI: So what are they doing right?
DV: It’s a double-edged sword, because it’s going back to the warranty issue but they’re taking really good care of their customers. For example one person I spoke to said they had a windshield crack and the insurance company said the cost is going to be around $1,000 and Tesla stepped up and said they would replace it under warranty. That’s really good customer service, but what’s a little concerning is that it also affects that warranty issue. It’s the right way to go by instilling confidence in the brand by providing superb customer service, which they seem to be doing. The performance of the car I think is really good. How it performs as the battery starts to age and so forth remains to be seen. But I think in the segment they are in, they’re producing a good product.
BI: Anything else our readers should know?
DV: Another concern I think people need to be thinking about going forward is they’re guaranteeing the residual value on cars that are leased going forward. That can create some real headaches, because residual values are such an unknown at this point. And if they’re guaranteeing a relatively high residual value, which they need to do to make the car more affordable, on the back end they could be stuck with a lot of vehicles that have far less residual value than what they’ve estimated.
Depending on how many people take that lease option it’s also going to cause some issues with regard to how they go about measuring their profit because right now its just their vehicles sold and the selling price is your revenue whereas anything that is effectively leased under this new arrangement you just get periodic payments coming in that count towards your revenue. …This is going to cause slower growth in revenue.”
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